EAST ASIA: A DECADE AFTERdecember 15, 2007 Economic & Political Weekly36Continuity or Change? Finance Capital in Developing Countries a Decade after the Asian CrisisC P ChandrasekharTen years after the east Asian crisis, the volume of capital flows to developing countries has exploded, but has vulnerability to crises been reduced because of the prudence built into the financial system? On the contrary, we are in fact witnessing trends, which imply an increase in financial fragility that can lead to further crises, with extremely adverse implications for growth, stability, employment and social welfare. New measures to govern finance and financial flows are a necessity.July 2007 marked the completion of a decade since the Asian financial crisis subverted the growth miracle in east Asia. Prior to the crisis the pace and pattern of growth in many countries in that region were challenging the dominance of the original capitalist powers over the global economy. The crisis set back that process, and even after a decade many of these coun-tries have not been able to recover their pre-crisis dynamism.The crises in east Asia and in many other developing countries have focused attention on a number of dangers associated with a world dominated by fluid finance. In particular, they have sent out the message that if countries choose to liberalise their financial poli-cies to attract financial investors to their markets, they are prone to boom-bust cycles, with adverse implications for the real economy.Speculative TendenciesUnderlying these financial cycles have been speculative tenden-cies fostered by financial liberalisation and globalisation. These tendencies rendered global financial institutions prone to over-exposure in individual markets often as a result of unsound financial practices. A combination of the competitive thrust for speculative gains on funds garnered from profit-hungry investors, the herd instinct characteristic of financial investors, and the moral hazard generated by an implicit guarantee from the state that the financial system would be bailed out in periods of crisis, all resulted in a situation where lending to and financial invest-ments in particular countries continued well after there was evi-dence that high-risk exposure had exceeded warranted limits. The corollary of this was that supply-side factors were likely to result in boom-bust cycles in financial flows to developing coun-tries, with a surge in such flows followed in all likelihood by a sudden collapse of such flows.The capital that drives this supply-side push originates in the transformation of capitalism that has occurred under the tutelage of neoliberal and neoconservative ideologies. The growing inequality characterising an unregulated capitalism, in which wages stagnate while productivity and profits rise, has resulted in the accumulation C P Chandrasekhar (cpchand@gmail.com) is at the Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi.The articles in this special issue are the revised papers of presenta-tions made at the conference ‘A Decade After: Recovery and Adjust-ment since the East Asian Crisis’, held on July 12-14, 2007, in Bangkok, and organised by the International Development Economics Associates, Global Sustainability and Environment Institute, Thailand, and Focus on the Global South. EPW is grateful to C P Chandrasekhar for help in putting together this special issue.
EAST ASIA: A DECADE AFTEREconomic & Political Weekly december 15, 200737of vast sums of capital in the hands of a few investors in the metropolitan centres of global capitalism.1 These gains are lightly taxed by governments that are not committed to appropriating a part of the surpluses of the rich to improve the welfare of the poor. Lower down the ladder, investment capital accumulates with mutual and pension funds in which less protected populations deposit the savings they put aside to insure theirfuture.Thelackofstate-funded welfare in today’s more liberalisedandopencapitalism is forcing the middle classes in the developed countriestosaveby subscribing to these funds that have become important sources of financial capital. Financial firms in the developed countries leverage capital from these sources by borrowing huge sums and use the resulting corpus to indulge in financial speculation. The problem is that the crises resulting from this process do not remain restricted to the financial sector. When the surge in capital flows is reversed, a massive liquidity crunch and a wave of bankruptcies follow. This results in severe deflation, with attendant consequences for employment and the standard of living. Asset prices collapse and pave the wave for international acquisitions of domestic firms at low prices denominated in cur-rencies that have substantially depreciated. A crisis triggered by finance capital becomes the prelude for conquest by international capital in general, with substantial changes in the ownership structure of domestic assets without much greenfield investment.These messages, driven home by the east Asian crisis, triggered a debate on policies that needed to be pursued at national and international levels to prevent the recurrence of boom-bust cycles of this kind. The intent here is not to track the efforts at fashion-ing a “new international financial architecture” or list the policies that were adopted in individual countries in response tofinancialcrises. The question is, a decade after, are we in a worldwhereunbridled capital flows are not inimical to stable growth, where vulnerability is reduced because of the pru-dence built into the financial system, and where the probability of financial crisis that can set back decades of advance in social welfare is significantly lower?1 The Burgeoning of FinanceIn terms of magnitude, finance capital has expanded massively during the last decade. Measuring the absolute size of globally dispersed finance capital is indeed a difficult proposition. Given the diversity of agents, instruments and markets and the lack of transparency in certain over-the-counter markets, it is extremely difficult to gauge the size of the corpus that functions as financial capital. But the available figures do point to galloping growth in the global operations of financial firms. One obvious form it has taken ever since the international lending boom of the late 1970s and after is the expansion of banks in the developed industrial countries into less developed countries, especially the so-called “emerging markets”. The net result was an increase in the international assets of the big banks of the devel-oped world. This trend has only gained strength in recent years. At the time of the east Asian crisis (end of June 1997), 23 countries reporting to the Bank of International Settlements, reported that the international asset position of banks resident in those countries stood at $9.95 trillion, involving $8.6 trillion in external assets after adjusting for local assets in international currencies [Bank of International Settlements, Monetary and Economic Department, 1997]. By December 2006, when 40 countrieswerereporting, this had risen to $32.14 trillion, with externalassetstotalling$28.48 trillion [Bank of International Settlements 2007]. This expansion in international asset position was not only the result of the increase in the reporting countries. The trend was visible in countries that reported on both dates as well. Thus, the international assets of UK-based banks had increased from $1.5 trillion to $5.8 trillion, and that ofUS banks from 0.74 trillion to $2.6 trillion.But this was not all. Increasingly, non-bank financial firms – pension funds, insurance companies and mutual funds – have emerged as important intermediaries between savers and investors. According to the Bank of International Settlements study [Committee on the Global Financial System 2007: 5], the total financial assets of institutional investors stood at $46 trillion in 2005. Of this, insurance firms accounted for close to $17 trillion, pension funds for $12.8 trillion and mutual funds for $16.2 trillion. The US dominated, accounting for as much as $21.8 trillion of institutional investors’ assets, while the UK was far behind at just $4 trillion. Here too, growth has been rapid with total assets more than doubling between 1995 and 2005 from $10.5 trillion in the US and $1.8 trillion in the case of the UK. The assets of autonomous pension funds in the US, for example, rose from $786 billion in 1980, to $1.8 trillion in 1985, $2.7 trillion in 1990, $4.8 trillion in 1995, $7.4 trillion in 2000 and $8 trillion in 2004 [Organisation for Economic Cooperation and Development 2001 and 2003].Growth of Assets of Hedge Funds and Private EquityBesides these institutions there are other less regulated and opaque institutions, particularly highly leveraged institutions like the hedge funds and private equity firms, which directly manage financial assets for high net worth individuals, besides the institutional investors themselves. Assets managed by around 9,000 surviving hedge funds are now placed at around $1.6 trillion [Financial Stability Forum 2007]. And, according to one study, private equity assets under management are nearing $400 billion in theUS and just under $200 billion in Europe. Private equity expansion is also reportedly strong with aggregate deal value grow-ing at 51 per cent annually from 2001 to 2005 in North America.2Transactions other than in debt and equity by these entities have also risen rapidly. In 1992, the daily volume of foreign exchange transactions in international financial markets stood at $820 billion, compared to the annual world merchandise exports of $3.8 trillion or a daily value of world merchandise trade of $10.3 billion. According to a recentBIS report [Bank of International Settlements 2007b: 5] the average daily turnover (adjusted for double-counting) in foreign exchange markets rose from $800 billion in 1992 to $1.5 trillion in 1998, before declining to $1.2trillionin2001.It then rose to $1.9 trillion in 2004 and sharplyto$3.2trillionin 2007. With the average GDP generated globally in a day standing at close to $100 trillion in 2003, this appears to be a small 3 per cent relative to real economic activity across the globe. But the sum involved is huge relative to the daily value of world trade. In 2006, the annual value of world merchandise exports touched $11.8 trillion, while that of commercial services trade rose to $2.7 
EAST ASIA: A DECADE AFTERdecember 15, 2007 Economic & Political Weekly38trillion. Thus the daily volume of transactions in foreign exchange markets exceeded the annual value of trade in commercial services and was close to a third of the annual merchandise trade.More significant is the trade in derivatives. The BIS estimates [Bank of International Settlements 2007b: 10] that the average daily turnover of exchange traded derivatives amounted to $6.2 trillion in April 2007, as compared with $4.5 trillion in 2004, $2.2 trillion in 2001 and $1.4 trillion in 1998. In the over-the-counter (OTC) derivatives market, average daily turnover amounted to another $2 trillion in 2007 at current exchange rates (as compared with $1.2 trillion, $575 billion and $375 billion respectively in 2004, 2001 and 1998). Thus total derivatives trading stood at $8.2 tril-lion a day, which together with the $3.2 trillion daily turnover in foreign exchange markets adds up to $11.4 trillion. This almost equals the annual value of global merchandise exports in 2006.Unprecedented LiquidityAll of this has meant that liquidity in the international financial system has been at unprecedented levels, ensuring that the pres-sures to push funds into emerging markets that prevailed at the time of the debt crisis in the 1980s and the east Asian crisis in 1997 has only intensified. The massive increase in international liquidity that these developments imply have found banks and non-bank financial institutions desperately searching for means to keep their capital moving.One consequence of these developments is that at different points in time, one or another group of developing countries has been dis-covered as a “favourable” destination for foreign financial investors. Increased competition and falling returns in the developed countries are also encouraging financial firms to seek out new opportunities in emerging markets. This supply side push can translate itself into an actual flow only when developing countries as a group, and the so-called emerging markets among them, relax controls on the inflow of capital and the repatriation of profits and investment as well as liber-alise their financial systems to accommodate international players and their operating strategies. In practice, despite the east Asian crisis and the number of other similar crises that have followed it in other parts of the world, and the evidence that such crises result from more open capital accounts, developing countries have competed with each other to attract these inflows.2 Capital Flows to Developing Countries: New TrendsOverall, the willingness to accommodate supply-side pressures has had rather dramatic implications for capital flows to developing countries. The first of these is an acceleration of financial flows to developing countries precisely during the years when as a group they have been characterised by rising surpluses on their current account. Total flows touched a record $571 billion in 2006, having risen by 19 per cent on top of an average growth of 40 per cent dur-ing the three previous years. Relative to the GDP of these countries, total flows, at 5.1 per cent, are at levels they touched at the time of the east Asian financial crisis in 1997 [figures in this section are from World Bank 2007].A second feature is the acceleration of the long-term tendency for private flows to dominate over official (bilateral and multi-lateral) flows. Private debt and equity inflows, which had risen by 50 per cent a year over the three years ending 2005, increased a further 17 per cent in 2006 to touch a record $647 billion. On the other hand, net official lending has in fact declined over the last two years, partly because some developing countries have chosen to make advance repayments of debt owed to official creditors, especially theIMF and the World Bank.The third feature is that after a period immediately following the 1997 crisis, when debt flows had almost dried up, in recent years both equity and debt flows to developing countries have risen rapidly. Net private debt and equity flows to developing countries have risen from a little less that $170 billion in 2002 to close to $647 billion in 2006, an almost fourfold increase over a four-year period. While net private equity flows, which rose from $163 billion to $419 billion dominated the surge, net private debt flows too increased rapidly. Bond issues rose from $10.4 billion to $49.3 billion and borrowing from international banks from $2.3 billion to a huge $112.2 billion. What is more, net short-term debt, outflows of which tend to trigger financial crises, has risen from around half a billion in 2002 to $72 billion in 2006.The fourth feature, which is a corollary of these developments, is that there is a high degree of concentration of flows to developing countries, implying excess exposure in a few countries. Ten countries (out of 135) accounted for 60 per cent of all borrowing during 2002-04, and that proportion has risen subsequently to touch three-fourths in 2006. In the portfolio equity market, flows to developing countries were directed at acquiring a share in equity either through the sec-ondary market or by buying into initial public offers (IPOs). IPOs dom-inated in 2006, accounting for $53 billion of the $96 billion inflow. But here too there were signs of concentration. Four of the 10 largest IPOs were by Chinese companies, accounting for two-thirds of total IPO value. Another 3 of those 10 were by Russian companies, account-ing for an additional 22 per cent of IPO value.Finally, despite this rapid rise in developing country exposure, with that exposure being excessively concentrated in a few coun-tries, the market is still overtly optimistic. Ratings upgrades dominate downgrades in the bond market. And bond market spreads are at unusual lows. This optimism indicates that risk as-sessments are pro-cyclical, underestimating risk when invest-ments are booming, and overestimating risks when markets turn downwards. But two consequences are the herding of investors in developing country markets and their willingness to invest a larger volume of money in risky, unrated instruments.In sum, we are now witnessing a return to a period when large and rising inflows, herd behaviour and overexposure have come to char-acterise capital flows from the north to the south. Is there reason to believe that this time around these developments are benign, or even positive, from the point of view of the developing countries as some would suggest? Besides the many crises that have occurred across the developing world, including in Argentina and Turkey, during the decade since 1997, structural changes in the global financial system suggest that risk, including systemic risk has only increased.3 Structural Transformation of Global FinanceThe rapid rise of capital flows to developing countries has as-sociated with it the institutional globalisation of international finance. During the 1990s, the three-decade long process of 
EAST ASIA: A DECADE AFTEREconomic & Political Weekly december 15, 200739proliferation and rise to dominance of finance in the global econ-omyreached a new phase. Characteristic of that was a growing process of financial consolidation that was concentrating financial activityand financial decision-making in a few economic organi-sations and integrating hitherto demarcated areas of financial activitythat had been dissociated from each other to ensure trans-parency and discourage unsound financial practices.A study [Group of 10 2001] of financial consolidation commis-sioned by finance ministers and central bank governors of the Group of 103 found, as expected, that there had been a high level of merger and acquisition (M&A) activity in the study countries during the 1990s, with an acceleration of such activity especially in the last three years of the decade. The number of acquisitions by financial firms from the survey countries increased from around 337 in 1990 to between 900 and 1000 by the end of the decade. Further, the average value of each of these acquisitions had increased from $224 million in 1990 to $649 billion in 1999. Clearly,M&A in the financial sector was creating large and complex financial organisations in the international financial system.Further, over the 1990s as a whole the evidence seems to be that M&A activity was largely industry-specific, with banking firms tending to merge dominantly with other banks. However, the pattern was changing over time. While in 1994 there was one instance of cross-industryM&A for every five instances of intra-industry mergers, the ratio had come down to one in every three by 1999. The merger and acquisition drive within the financial sector was not merely creating large and excessively powerful organisations, but firms that straddle the financial sector. Exploiting the process of financial liberalisation these firms were breaking down the “Chinese walls” that had been built between different segments of the financial sector.Surge in FDIGiven the wave of financial liberalisation in the developing world, it was inevitable that this process would effect developing countriesas well. According to a study by the committee on the Global Financial System or CGFS (2004) there was a surge in foreign direct investment in the financial sectors of developing countries. The study, by using cross-borderM&As targeting banks in emerging market economies (EMEs), found that cross-border deals involving financial institutions fromEMEs as targets, which accounted for 18 per cent of suchM&A deals worldwide during 1990-96, rose to 30 per cent during 1997-2000. The value of financial sectorFDI rose from about $6 billion during 1990-96 to $50 billion during the next four years. SuchFDI peaked at $20 billion in 2001, declined sharply in 2002, but stabilised in 2003. The net result is a clear shift in the ownership structure of the financial sector (Table 1). Anecdotal evidence indicates that this figure would have risen sharply since then.Turning to Asia,CGFS found that: “The proportion of cross-border M&As in east Asia’s financial sector initially was small compared with other regions. The value of cross-borderM&As targeting non-Japan Asian countries was $14 billion or 17 per cent of the total during 1990-2003. Asia, however, has been one of the fastest growing target regions for M&A, with a sizeable jump in cross-borderM&A activity occurring in Korea and Thailand. In addition, there has been a large number of small-value cross-border M&A transactions in the finance sector between east Asian economies. In 2003, Asia received the largest share of financial sector FDI inflows.”While liberalisation and the high returns offered by the hitherto protected financial market offered new opportunities, financial crises favoured globalisation. As the CGFS study notes: “A standard response to crises byEME governments, encouraged by the international financial institutions, was to accelerate financial liberalisation and to recapitalise banks with the help of foreign investors. This was the case in Latin America in the years following the 1994 Mexican crisis.” In Asia also governments liberalised the terms of foreign entry and ownership after the crisis,but because of a major role played by governments in the recapitalisation of banks, the expansion of foreign presence came with a delay.Thus, the global financial system is obviously characterised by a high degree of centralisation. WithUS financial institutions intermediating global capital flows, the investment decisions of afew individuals in a few institutions virtually determine the nature of the “exposure” of the global financial system. The grow-ing presence of a few international players in the developing countries and the consolidation of these players had implications for the accumulation of risk in markets where agents tend to herd. Unfortunately, unregulated entities making huge profits on highly speculative investments are at the core of that system.4 NewInstitutionsLiberalisation has not just increased consolidation and global inte-gration of the banking industry in developing countries. Many of them are now home to the activities of institutions like hedge funds Table 1: Ownership Structure in the Banking Systems of Emerging Market Economies1Country 199020022 DomesticForeignDomesticForeign Private3 Government PrivateGovernmentAsia China 0 100 0 98 24 Hong Kong SAR 11 0 89 28 72 Indonesia … … 4 37 51 13 India 4 91 5 12 80 8 Korea 75 21 4 62 30 8 Malaysia … … … 72 18 Philippines 84 7 9 70 12 18 Singapore 11 0 89 24 0 76 Thailand 82 13 5 51 31 18Latin America Argentina … 365 10 6 193348 Brazil 30 64 6 27 46 27 Chile 62 19 19 46 13 42 Mexico 1 97 2 18 0 82 Peru 41 55 4 43 11 46 Venezuela 93 6 7 1 7 39 27 34Central and eastern Europe Bulgaria … … 0 20 13 67 CzechRepublic 125 78 5 105 14482 Estonia … … … 1 0 99 Hungary 9 81 10 11 27 62 Poland 177 807 3 7 101763 Russia … … 6 23 68 9 Slovakia … … 0 9 5 85(1) Percentage share of total bank assets. 2002 figures for central and eastern Europe: percentage share of regulatory capital. (2) Data are shown for the latest year available, which is mainly 2002. (3) Calculated as residual. (4) 1999. (5) 1994. (6) Average of 1988-93. (7) 1993. Source: CGFS (2004). 
EAST ASIA: A DECADE AFTERdecember 15, 2007 Economic & Political Weekly40and private equity firms that are loosely regulated in the developed countries, are highly leveraged and pursue unconventional, specu-lative and risky investment strategies in relatively illiquid assets aimed at exploiting mispricing and arbitrage opportunities to en-sure high returns for their investors. With investment banks and fund managers adopting practices similar to these entities the dis-tinction between these and other financial institutions is blurring at the level of activity, excepting perhaps for the concentration of the activities of these entities on specific kinds of trades. Many years back, the Group of 30 had cautioned governments that these funds were a source of concern because they were prone to “undercapitalisation, faulty systems, inadequate super-vision and human error”. While controversial for long, hedge funds gained notoriety in 1992 when George Soros’ Quantum Fund was held responsible for the speculative attack on the British pound and in the late 1990s with the collapse of the much publicised Long Term Capital Management with its star traders, Nobel-winning economists and high-return track record. For developing countries, their notoriety was linked to the role they are alleged to have played in the currency speculation that precipitated the 1997 crisis.Yet hedge fund activity in developing countries has increased substantially in recent years, including in Asia. Encouraged by liberalisation that ensures not only entry but the proliferation of instruments, the growth of derivatives markets, the emergence of futures, and the increase in shorting possibilities, these firms have devoted much attention to these markets. According to one estimate quoted by the Financial Stability Forum (2007), the share of hedge fund assets managed in Asia has risen from 5 per cent in 2002 to 8 per cent in 2006. These increases have been at the expense of the US, which while recording a significant increase in hedge fund activity in absolute terms, has seen a decline in share of the global total from more than 80 per cent in 2002 to about 65 per cent in 2006.Private Equity FundsBesides hedge funds, portfolio diversification by financial in-vestors in developed countries seeking new targets, higher returns and/or a hedge, the last quarter of a century has seen a revival of private equity firms. Private equity, as originally broadly defined, involves investment in equity linked to an asset that is not listed and therefore not publicly traded in stock markets. Given this broad definition, a range of transactions and/or assets fall under its purview, including venture capital investments, leveraged buyouts and mezzanine debt financing, where the creditor expects to gain from the appreciation in equity value by exploit-ing conversion features such as rights, warrants or options.While private equity has been growing rapidly, its activities in the developed countries is being curbed by the growing opposi-tion to these firms and their activities. A major criticism of private equity firms is their lack of transparency. Besides, they are being accused of wielding the hatchet against workers or breaking up companies when firms are being restructured. One result of all this is that private equity firms are finding their business getting harder to conduct in the US and Europe. Not surprisingly, there are signs that the business is increasingly moving overseas, especially to emerging market countries where markets are booming because of foreign institutional investment inflows. According to Emerging Markets Private Equity Association, fundraising for emerging market private equity surged in 2005 and 2006. Estimated at $3.4 billion and $5.8 billion in 2003 and 2004, the figure shot up to $22.1 billion in 2004 and $21.9 billion in 2006(uptoNovember 1). Asia (excluding Japan), Australia and New Zealand dominated the surge, with the figure risingfrom $2.2 and $2.8 billion in 2003 and 2004 to $15.4 billionduring2005 and $14.5 billion during the first 10 months of 2006.Dealmaking in the region has also gained momentum. Dealogic estimates that the value of private equity deals in the Asia Pacific, excluding Japan, more than tripled to $26 billion in 2006 from $7 billion in 2005 [Metrics 2.0, 2006]. Private equity buyouts have accounted for 7 per cent of regional merger and acquisition volume in 2006, up from 3 per cent in 2005 but still below the global figure of 17 per cent. Though Australia accounted for $11.7 billion in activity, deals in the Indian subcontinent jumped to $3.1 billion in 2006 from $764 million in 2005, with Kohlberg Kravis Roberts & Co’s $900 million purchase of Flextronics Software Systems, India’s largest deal. North Asia deals totalled $10.4 bil-lion, led by Goldman Sachs’ $2.6 billion investment in Industrial and Commercial Bank of China, this year’s biggest regional deal. Investment banks have raked in $304 million in netreve-nue from private equity investors thus far in 2006, compared with $239 million last year.5 Transformation of the Financial SectorThe evidence of a rising foreign presence in the financial sector in developing countries suggests that the flow of capital is accompa-nied by the movement of firms and institutions from the devel-oped to the developing. Countries wanting to attract financial in-vestments have to accommodate financial investors as well. Fur-ther, when these entities are permitted to enter developing country markets, they would be interested in the replication of their trad-ing practices in the new environment. Policies of financial liberali-sation are, inter alia, meant to meet these requirements of finance capital in countries seeking to attract financial investments. Finan-cial liberalisation therefore: (i) opens the country to new forms and larger volumes of international financial flows; (ii) allows entry of foreign financial entities, varying from banks to private equity firms, into the country; and (iii) dilutes or dismantles regu-lation and control that does not permit or curbs the operation of the entities and the pursuit of their preferred practices. A conse-quence of such liberalisation is financial consolidation and the proliferation of new institutions and instruments.It has been argued for sometime now, and especially since the east Asian crisis, that the first of the above features of financial liberalisation, involving liberalisation of controls on inflows and outflows of capital respectively, has resulted in an increase in financial fragility in developing countries, making them prone to periodic financial and currency crises.Analyses of individual instances of crises have tended to con-clude that the nature and timing of these crises had much to do with the shift to a more liberal and open financial regime. What is less 
EAST ASIA: A DECADE AFTEREconomic & Political Weekly december 15, 200741emphasised is the vulnerability that stems from the proliferation of new kinds of foreign institutions, new instruments and new business practices in the wake of liberalisation. As we have seen the increase in the extent and width of liberalisation over the last decade has not only led to the surge in capital flows in recent years but encouraged the entry of speculative investors adopting unusual lending and investment practices in environments that are even less regulated than the US, for example. This would, therefore, have substantially increased rather than reduced financial vulnerability over the last decade.6 Signs of VulnerabilityOne obvious instance of such an increase in vulnerability is the mas-sive “boom” in their stock markets that emerging markets across the Asian region are experiencing (see Appendix Charts). Market observ-ers, the financial media and a range of analysts agree that foreign in-vestments have been an important force, even if not always the only one, driving markets to their unprecedented highs. There are a number of reasons why this trend points to vulnerability. To start with, the spike in stock prices is extremely sharp. Second, this boom is generalised and occurs independent of the relative economic per-formance of the country concerned. This not only implies that funda-mentals do not have the prime role in determining the behaviour of markets, it also means that the danger of contagion is real. Third, this occurs both in countries where investors have burnt their fingers in 1997 and in those they have not.A second indicator of vulnerability is the revival of the credit spiral, which underlay the east Asian crisis. It was no doubt true that in the years immediately following the crisis, the flow of private non-guaranteed debt to developing countries as a group fell till 2000 and registered a marginal decline in the sub-sequent two years to 2002 (Table 2).With governments wanting to discourage debt-dependence, and creditors wary of lending any further, even public and publicly guar-anteed debt from private credi-tors registered a sharp decline during those years. But matters seem to have changed dramatically over the last four years. The flow of non-guaranteed debt from private sources into developing countries has increased by 250 per cent over the four years ending 2006, or at a scorching pace of 28 per cent compound per annum. Simultaneously, governments too seem to have overcome their fear of debt with public or publicly guaranteed debt from pri-vate creditors having risen by more than 150 per cent orgrowing at a compound rate of around 11 per cent per annum. Insum, creditors appear willing to lend and debtors willing to borrow, resulting in an aggregate scenario that spells debt dependence of a much larger magnitude than preceded the 1997 crisis.There has been some change in composition by source as well. While in the immediate aftermath of the 1997 crisis, the relatively small inflow of debt was on account of bond issues by developing countries, with bank credit collapsing and turning negative, in more recent years there has been a revival of bank credit. In terms of target, as was happening at the time of the crisis there is a sharp shift in bor-rowing away from the public to the private sector. The corporate share of external debt has risen from less than one-fifth of the total in the late 1990s to more than one-half in 2006. What is disturbing is the extreme concentration of these flows, with a growing and now substantial share of it flowing to Europe and central Asia. In 2006, 57 per cent of flows of private non-guaranteed debt went to this region while east Asia and the Pacific received 14 per cent and Latin America and the Caribbean 19 per cent. Just 10 countries accounted for thee-fourths of all borrowing in 2006, a sharp increase from the already high 60 per cent average during 2002-04. What is more, the evidence points to a growing share of lending to banks in developing countries, interested in exploiting the lower interest rates in international as opposed to domestic markets. Loan commitments to the bank-ing sector totalled $32 billion in 2006, which exceeded commit-ments to the oil and gas sector, a traditional leader.Finally, the World Bank’s reportGlobal Development Finance 2007 suggests that there has been a decline in credit quality ac-companying these developments. To quote: “As private debt flows swell, riskier borrowers may be taking a larger share of the market. The share of bonds issued by unrated (sovereign and corporate) borrowers rose from 10 per cent in 2000 to 37 per cent in 2006, and the share of unsecured loans in total bank lending rose from 50 per cent in 2002 to almost 80 per cent in 2006” [World Bank 2007: 47].The point to note, however, is that despite these disconcerting trends creditor confidence is at a high. The average spread between interest rates charged on developing country loan com-mitments and the benchmarkLIBOR fell from more than 200 basis points in 2002 to 125 in 2006 and the average loan maturi-ties have become longer.The inevitable conclusion from this evidence that needs explaining is that creditors are not pricing risk adequately and taking it into ac-count when determining exposures. One explanation could be that creditor profiles have changed significantly, with the entry of interme-diaries such as hedge funds and other less risk-averse entities into the credit market. The other could be the growing role of credit deriva-tives, which allows for the pooling of risk and the transfer of risk to entities that are less capable of assessing them.According to figures reported by the Financial Times The outstanding notional volume of credit derivatives contracts has doubled every year since the start of this decade to reach $26,000bn in the middle of last year. This has led many traditional credit investors to rethink their strategies. But above all, it has triggered a sharp in-crease in the number and scale of credit-focused hedge funds. In 1990, according to Hedge Fund Research, hedge funds focused on fixed in-come strategies accounted for just over 3 per cent of the $39bn of as-sets under management in the industry. By the end of lastyear, a more variedarrayofcredit-relatedstrategies accounted for almost 7.5 per cent of a $1,400bn industry – and that does not include convertible bond arbitrage. Similarly, the volume of assets under management in fixed-income arbitrage strategies alone, which seek to exploit price differ-ences between related bonds and rely heavily on derivatives, has leapt from $5.8bn in 2001 to $41bn at the end of 2006, according to HFR [Davies and Beales 2007]. Since these developments are also taking place in the emerg-ing markets, hedge funds are looking for a role there as well.Table 2: Structure of Private Credit to Developing Countries($ bn) BondsBanksOthersShort-termTotal1998 38.8 49.4 -5.3 -65.3 17.61999 30.1 -5.3 -1.5 -17.3 62000 20.9 -3.8 -3.7 -6.3 7.12001 10.3 7.8 -6.5 -23.7 -12.12002 10.4 2.3 -6.9 0.5 6.32003 24.7 14.5 -4.4 55 89.82004 39.8 50.6 -4 68.4 154.82005 55.1 86 -4.9 67.7 203.92006e 49.3 112.2 -5.5 72 228Source: World Bank (2007).
EAST ASIA: A DECADE AFTERdecember 15, 2007 Economic & Political Weekly42These two aspects are indeed related. The emergence of credit derivatives has rendered credit assets tradable. This allows those looking for quick or early profits to operate in this area. But even here financial innovation has played a role. Till recently, other than banks, the major players in the credit business were pension funds and insurers. But with equities proving to be inadequately remunerative investments, banks increasingly geared to creating new instruments based on debt, and credit derivatives offering liquid credit instruments, new players – hedge funds and pension funds – have emerged as investors and new operators – specialised credit funds and managers of collateralised debt obligations – have emerged as providers of instruments.7 FinancialEntanglement and Emerging MarketsJust as the world was recalling the 1997 Asian financial crisis on its 10th anniversary, the dangers associated with the accumula-tion of risk in emerging markets were driven home by the simul-taneous collapse of stock indices in the worlds leading financial markets on Friday, July 27, 2007, including those in so-called “emerging markets” in developing countries. What is disconcert-ing is that this synchronised collapse of markets was not the result of developments in each of the countries where these markets were located. Rather, the source of the problem was a crisis brewing in the housing finance market in theUS, the ripple effects of which encouraged investors to pull out of markets globally. Since then, with the central banks of the developed countries moving in to reduce interest rates and inject liquidity into markets, the latter have recovered. But they remain volatile and prone to a downturn.Underlying these ripple effects is the financial entanglement which results from the layered financial structure, the “innova-tive” financial products and the inadequate financial regulation associated with the increasingly liberalised and globalised finan-cial systems in most countries. Few deny that the sub-prime hous-ing loan market in theUS – consisting of loans to borrowers with a poor credit record – is faced with a crisis, reflected in payment defaults and foreclosures. The problem lies in the way in which the preceding boom was triggered and kept going. Housing demand grew rapidly because of easy access to credit, with even borrowers with low creditworthiness scores, who would otherwise be considered incapable of servicing debt, being drawn into the credit net. These sub-prime borrowers were offered credit at higher rates of interest, which were sweetened by special treatment and unusual financing arrangements – little documentation or mere self-certification of income, no or little down payment, extend-ed repayment periods and structured payment schedules in-volving low interest rates in the initial phases which were “ad-justable” and move sharply upwards when they are “reset” to reflect premia on market interest rates. All of these encouraged or even tempted high-risk borrowers to take on loans they could ill-afford, either because they had not fully understood the repayment burden they were taking on or because they chose to conceal their actual incomes and take a bet on building wealth with debt in a market that was booming.What needs to be understood, however, is the problem is large-ly a supply-side creation driven by factors such as easy liquidity and lower interest rates. Utilising these circumstances mortgage brokers attracted clients by relaxing income documentation re-quirements or offering grace periods with lower interest rates, on the completion of which higher rates kick in. As a result, the share of such sub-prime loans in all mortgages rose sharply. Estimates vary, but according to one by Inside Mortgage Finance quoted by theNew York Times [Creswell and Bajaj 2007], sub-prime loans touched $600 billion in 2006, or 20 per cent of the mortgage loan total as compared with just 5 per cent in 2001.The increase in this type of credit occurred because of the complex nature of current-day finance that allows an array of agents to earn lucrative returns even while transferring the risk associated with the investments that offer those returns, Mort-gage brokers seek out and find willing borrowers for a fee, taking on excess risk in search of volumes. Mortgage lenders finance these mortgages not with the intention of garnering the interest and amortisation flows associated with such lending, but because they can sell these mortgages to Wall Street banks. The Wall Street banks buy these mortgages because they can bundle assets with varying returns to create securities or collat-eralised debt obligations, involving tranches with differing prob-abilities of default and differential protection against losses. They charge hefty fees for structuring these products and valuing them with complex mathematical models, before selling them to a range of investors such as banks, mutual funds, pension funds and in-surance companies. These entities in turn can then create a port-folio involving varying degrees of risk and different streams of future cash flows linked to the original mortgage. To boot, thereare firms like the unregulated hedge funds, which make speculative investments in derivatives of various kinds in search of high re-turns for their high net worth investors. Needless to say, institutions at every level are not fully rid of risks but those risks are shared and rest in large measure with the final investors in the chain.This structure is relatively stable so long as defaults are a small proportion of the total. But if as the share of sub-prime mortgages in the total rises the proportion of defaults increases, the bottom of the barrel gives and all assets turn illiquid. Rising foreclosures affect property prices and saleability adversely as foreclosed as-sets are put up for sale at a time when credit is squeezed because lenders turn wary. And securities built on these mortgages turn illiquid because there are few buyers for assets whose values are opaque since there is no ready market for them. The net result is a situation of a kind where a leading Wall Street bank like Bear Stearns has to declare that investments in two funds it created linked to mortgage-backed securities were worthless. The inves-tors themselves have to sell off other assets to rebalance their portfolios, sending ripples into markets such as those in develop-ing countries that have little to do with theUS sub-prime market.Beyond Wall Street BanksThe problem is not restricted to the Wall Street banks. For example, in early August 2007, the French bankBNP Paribas suspended with-drawals from three of its funds exposed to the mortgage-backed securities market. The bank reportedly attributed its decision 
EAST ASIA: A DECADE AFTEREconomic & Political Weekly december 15, 200743to “the complete evaporation of liquidity in certain marketseg-ments”, which constrained it from meeting withdrawal demands that could have turned into a run on the fund. In some cases a bail-out becomes necessary, as was true of Dusseldorf-basedIKB bank, which through offshore front company, Rhineland Fund-ing, had invested as much as $17.5 billion in asset-backed securi-ties. As the value of its assets fell, Rhineland had to call on a Euro 12 billion line of credit that it had negotiated with a group of banks, including Deutsche Bank, besidesIKB itself. Deutsche Bank decided to opt out of its promise to lend, resulting in the discovery that the Fund had suffered huge losses and needed a bail-out led by state-owned KfW. And in the UK, Northern Rock, a top mortgage lender that is a bank that began as a hosing society, incurred losses in the sub-prime market and became the target of a bank run. Worried depositors began pulling out their money, forcing the Bank of England to intervene because of fears that the disease may spread to other banks. It offered Northern Rock funds to tide over the crisis and depositors a guarantee that their deposits were safe. In sum, the effects of the sub-prime crisis are weakening distant segments of the global financial system, as a result of financial entanglement.Entanglement also makes nonsense of the theory that a complex financial system with multiple institutions, securitisation, pro-liferating instruments and global reach is safer because of the fact that it spreads risk. This was illustrated by the example of IKB referred to above. Banks wanting to reduce the risk they carry resort to securitisation to transfer this risk. But institutions created by the banks themselves linked to them in today’s more univer-salised banking system or leveraged with bank finance often buy these instruments created to transfer risk. In the event, asThe Economist (‘Prime Movers’, August 11, 2007) put it, “banks (that) have shown risk out of the front door by selling loans, only ...let it return through the back door”. This it notes is what exactly tran-spires in the relationship between the three major prime broking firms – Goldman Sachs, Morgan Stanley and Bear Sterns – that offer prime broking services, including loans, to highly lever-aged institutions like hedge funds. The bail-out of Long Term Capital Management in 1998 was necessitated because of entan-glement of this kind involving all the leading merchant banks.Investments by banks, pension funds and mutual funds are driven by the search for high and quick returns in a world of excess liquidity. In deciding to make investments on structured products intermediated at different levels, these institutions, ill-equipped to judge the true value and riskiness of these assets, rely on rating agencies. But these ratings have turned out to be unreliable and pro-cyclical, serving as erroneous and belatedly corrected signals. Noting that “in a matter of weeks thousands of portions of subprime debt issued as recently as 2005 and 2006 have had their ratings slashed”, The Economist (‘Sold Down the River Rhine’, August 11, 2007) argued that investors should not have trusted the original ratings because “the rating agencies were earning huge fees for providing favourable judgments”. What is more, even when there is no deception involved, rating agencies themselves are not equipped to assess these products and rely on information and models provided by the creators of the products themselves. Once an asset is rated there is much reluctance to downgrade it, because it would raise doubts about related ratings as well as trigger a sell-off that affects prices of related securities that may warrant further downgrades.The problem is that if these factors result in the accumulation of doubtful assets by investors such as banks, pension funds and mutual funds, any downturn spreads the effects into markets where these institutions have made unrelated investments. In fact, institutions overexposed to complex structured products whose valuation is difficult are saddled with relatively illiquid assets. If any development leads to liquidity problems they are forced to sell off their most liquid assets such as shares bought in booming emerging markets. The effect that this can have on those markets would be all the greater the larger the exposure of these institutions in these markets. Unfortunately, this is precisely what happened in July in most emerging markets including those in Asia.8 SummingUpIn sum, a decade after the 1997 crisis we are witnessing trends which imply an increase in financial fragility that can lead to fur-ther financial crises, with extremely adverse implications for growth, stability, employment and social welfare. This is the ele-ment of continuity in a world that is seen as having changed sub-stantially. Self-regulation clearly does not help. New measures to govern finance and financial flows are a necessity.There are many lessons that are once again being driven home by recent developments that are of particular significance for developing countries that are rapidly liberalising their financial systems. First, excess liquidity in a loosely controlled financial system, which encourages the flow of capital to developing countries, also provides the basis for speculative and unsound financial practices, such as excessive sub-prime lending that increases fragility. Sec-ond, such practices are encouraged by the “financial innovation” that liberalisation triggers, which increases the number of layers of intermediation and allows firms to transfer risk. As a result, those who create risky “products” in the first instance are less worried about the risk involved than they should be. Third, as the product moves up the financial chain, investors are less sure about the risk and value of these products than they should be, rendering even low risk, first-stage tranches prone to value loss. Fourth, this inadequate knowledge appears to be true even of the rating agencies on whose ratings investors rely, resulting in erro-neous ratings and belated rating downgrades. This implies that as and when a rating downgrade does occur, the asset turns worthless, since there is nobody willing to buy into the asset. Fifth, new forms of self-regulation appear to be poor substitutes for more rigorous control, since the current crisis originates in a country whose financial sector is considered the most sophisticated, well regulated and transparent and serves as a model for others reforming their financial sectors. And finally, financial globalisa-tion and entanglement imply that countries that have more open and integrated financial systems are prone to contagion effects, even if the virus originates in remote locations and markets. These are lessons that must inform policy in these so-called emerging markets.EAST ASIA: A DECADE AFTER
Notes
1 For example, the wealthiest 1 per cent of Americans reportedly earned 21.2 per cent of all income in 2005, according to data from the US Internal Revenue Service. This was an increase in share relative to the 19 per cent recorded in 2004, and exceeded the previous high of 20.8 per cent set in 2000, at the peak of the previous bull market in stocks. As compared with this, the bottom 50 per cent earned
2 Figures from Venture Economics, Private Equity, and Buyouts Magazine quoted in Bloomberg and Schumer (2006).
3 The study covered besides the 11 G-10 countries (US, Canada, Japan, Belgium, France, Germany, Italy, Netherlands, Sweden, Switzerland and UK), Spain and Australia.
References
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Creswell, J and V Bajaj (2007): ‘A Mortgage Crisis Begins to Spiral, and the Casualties Mount’, The New York Times, March 5.
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Chart 1: Movements in the Indian Composite Stock Index (Sensex, Base 1978-79 = 100) Chart 4: Movements in the Kuala Lumpur Stock Exchange Composite Index (Base January 3, 1974 = 100)
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Source: Global Financial Data at www.globalfinancialdata.com Source: Global Financial Data at www.globalfinancialdata.com
Chart 2: Movements in the Jakarata Stock Exchange Composite Index Chart 5: Movements in the Manila Stock Exchange Composite Index
(Base August 14, 1991 = 100)
(Base September 30, 1994 = 2922.21) 3,000
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0 1/2/1995 1/2/1996 1/2/1997 1/2/1998 1/2/1999 1/2/2000 1/2/2001 1/2/2002 1/2/2003 1/2/2004 1/2/2005 1/2/2006 1/2/2007
500 1/2/1995 1/2/1996 1/2/1997 1/2/1998 1/2/1999 1/2/2000 1/2/2001 1/2/2002 1/2/2003 1/2/2004 1/2/2005 1/2/2006 1/2/2007 Source: Global Financial Data at www.globalfinancialdata.com
Source: Global Financial Data at www.globalfinancialdata.com
Chart 3: Movements in the Korea Stock Exchange Stock Price Index
Chart 6: Movement in the Thailand SET General Index (Base August 1, 1975 = 100) (Base January 4, 1980 = 100) (g, )
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Source: Global Financial Data at www.globalfinancialdata.com Source: Global Financial Data at www.globalfinancialdata.com
december 15, 2007 Economic & Political Weekly
