The Asian Financial Crisis revisited
My review of Russell Napier's account of the crisis and its impact on today's financial non-system.
Russell Napier was CLSA’s Asia equities strategist from 1995 to 1998, which gave him a front-row seat to the Asian financial crisis. A few years ago, he wrote a book explaining the crisis. It’s an unusual history, largely drawing on Napier’s snappy research notes, each snippet followed by Napier’s looking back from the year 2020, putting things in context and noting when he got things right and when he didn’t.
Napier got the big things right, which frequently got him in trouble. CLSA – ye olde CLSA, nothing like what it is today – was a scrappy upstart that relied on smart, independent research to win brokerage commissions. (Such a business wouldn’t exist in today’s world of unbundled research.)
Its senior management tolerated Napier’s maverick macro research, but it drove his local sales teams crazy. They were trying to ride a huge bull market in Asian equities, and Napier’s job was to provide the big-picture view that the equities desks could use to develop trading ideas. But Napier’s message quickly turned bearish, and he often struggled to come up with a daily macro tip that wouldn’t get him fired.
He was lucky in his timing. Had he arrived a little earlier, he probably would have gotten the sack. But by the end of 1996, it was obvious to even an equity sales trader than the wheels in Thailand were coming off.
It’s hard for us today to appreciate the frenzy for Southeast Asian stocks. Due to index inclusion rules, “Asia ex-Japan” was for most global investors just Thailand, Malaysia, the Philippines, Indonesia, and Hong Kong and Singapore. China was uninvestible and widely mistrusted, its boom misunderstood. Taiwan, South Korea and India were difficult to access, Pakistan and Bangladesh too poor.
So while the great economic booms were taking place in North and South Asia, global investors were obsessed with Bangkok and KL. Napier delights in noting that the UK pensions and asset management industry, so skeptical of Silicon Valley-style entrepreneurialism while enamored of the high-growth story in Southeast Asia, actually had a greater allocation to the region than to Nasdaq. Truly one of the greatest collective screwups in investment history!
The boom was driven by Asian governments’ decision to peg their currencies to the US dollar. This regime became impossible to maintain as Southeast Asian countries gradually lost export competitiveness to China. Today we talk of the “China shock” but the first companies to be negatively impacted by Chinese manufacturing were in Southeast Asia, not in the West.
These countries came to increasingly rely on capital inflows to keep domestic GDP growth at unusually high rates. Napier sussed this was hot money and that it was bound to end: these inflows weren’t just taking advantage of Asian growth, they were the force driving it. It’s a bit like quantum physics: the act of observing a particle changes its nature, making the observer responsible for the particle’s behavior. Such an inversion in capital flows signaled trouble, both for the observers and the observed.
What Napier didn’t know at the time was the extent to which these inflows of capital weren’t from British or American portfolio investors or from FDI, but from Asian corporations and investors, who borrowed in US dollars to invest back in their domestic enterprises and property.
This hot money, fueled both by local borrowers and by global lenders, forced Asian central banks to intervene to maintain their currency pegs. They did so by buying dollars, and funded this by printing more domestic money. This led to an expansion in local banks’ P&Ls, so they kept lending at increasingly crazy levels. This in turn boosted local asset prices, attracting even more foreign capital.
It is the nature of financial markets that you end up with too much of a good thing. The greater the returns, the more the investment world was blinded to its own role in fomenting the bubble in countries that were relatively small, with undeveloped local banking systems. And when things did start to look shaky, Asian borrowers found Japanese banks were eager to join their European counterparts as providers of capital, prolonging the boom just a little longer.
Napier brought an understanding of credit markets and capital flows that stock investors lacked. Investors obsessed with Asia’s rising GDP numbers and assumed this would translate into equity returns. It did not. But equity investors weren’t the only ones to get it wrong: Asian policymakers doubled down on managing their currencies, oblivious to the damage they caused.
The crisis formally kicked off in July 2nd 1997, one day after the Hong Kong handover, when the Bank of Thailand abandoned its dollar peg. Many investors assumed the IMF or the US would ride to the rescue. They eventually did, but this morphed the AFC into a global tussle over the future of capitalism.
Napier notes that local governments, including Japan’s, wanted to preserve a style of capitalism that was based on relationships, not the rule of law. Asian authorities believed the purpose of any intervention should be to provide stability and not give into the whims of the market. Asian authorities wanted the IMF to calm the situation by providing capital, so they could return to business as usual.
The IMF, goaded by the US Treasury, wanted to impose Western financial capitalism on the region. The IMF wanted to end crony capitalism (and pave the way for Western multinationals to operate more efficiently in Asia). The pinnacle of this effort was forcing Indonesia’s President Suharto to partly dismember the cozy arrangements that kept his family and buddies enriched; soon the austerity of IMF programs would kindle unrest and trigger Suharto’s fall.
This struggle was expressed on the world stage in terms of values: Mahathir Mohammed in particular argued for “Asian values”, while denouncing George Soros and the IMF. Malaysia would opt for capital controls, temporarily halting the pain but setting the country’s economy, marked by its Malay affirmative-action preferences, in amber. Malaysia went beyond trying to preserve its local version of capitalism and embraced stagnation.
The crisis spread to Korea, whose companies and banks had built up a lot of debt that they suddenly couldn’t roll over when global lenders got cold feet on the region. Then it spread to Hong Kong in the form of a hedge-fund attack on the dollar peg and local stock market.
The crisis ebbed in late 1998 after foreign multinationals began picking up assets, mainly in Thailand and Malaysia. Their capital injections put a floor on asset prices. In Hong Kong, the Hong Kong Monetary Authority had to defend the peg by using its reserves to buy local equities – and initiating a new fondness for state intervention. (The alternative would have been for the People’s Bank of China to start buying HKD financial assets, so at least HKMA preserved its independence.)
I rocked up to Hong Kong in January 1997, clueless to all of this. I’ve since filled in many of the blanks, and I enjoyed reliving these events through Napier’s blow-by-blow account. His early research pieces can be droll:
“At Downpatrick Racecourse, at the foot of the Mourne mountains in Ireland, the quality of the field is rarely good. It seems that everybody in the country who made some money on the dogs upgrades to a horse. However, these same turf investors sometimes pay top dollar to get the best jockeys. The uninitiated punter often commits their hard-earned tenner to back a Dunwoody regardless of the quality of his mount. The punter believes that the owner must believe their horse to be a winner or otherwise why would they pay for a good jockey? The owner pays for a good jockey because they can and the punter waves goodbye to their tenner. Similarly, in Thailand, there is a belief that a new jockey (the IMF) can whip the bank and finance stocks into a dramatic outperforming run. Unfortunately, many of these mounts are set for the knacker’s yard and not the winning post.”
If this were simply a jocular recounting of an old crisis and a victory jog for the narrator, it would be an esoteric book indeed. However, the name of the book is now worth mentioning: The Asian Financial Crisis 1995-98: Birth of the Age of Debt.
Napier connects dots between the arguments over Western versus Asian finance that raged in the late 1990s – and the failure between East or West to establish a constructive dialogue – with the massive buildup of debt in the West that has gone hand in hand with its manufacturing decline and the dominance of financial engineering over real economic activity.
This development has also been a poor deal for ordinary Asians. Once things settled down, many Asian regimes returned to managed currencies, protectionism, and cronyism. The wiping out of the middle classes across many countries did not lead to a new balance of labor versus capital, or any form of welfare. It has left Southeast Asian countries less competitive. My own view is that Thailand and Malaysia have suffered two lost decades, while Indonesia has failed to establish itself as a meaningful alternative to China for global supply chains. Why has Vietnam, with a far less developed economy, been so successful?
I looked up a simple stat to illustrate this. The IMF figures for purchasing power parity show Singapore was about $40,000 at the time of the Asian financial crisis, about ten times more than Malaysia or Thailand. Today? Singapore international dollars per capita is $153,610, while for Malaysia it’s $43,100, and $26,420 for Thailand. It’s taken two decades for Malaysians to become as rich as Singaporeans were in 1998, while the rest of Southeast Asia is far from matching even that.
However, consumerism wasn’t the focus of Asian policymaking in the wake of the crisis. Across the region, starting with China, policymakers were determined to never have to rely on the IMF or the US again. That meant returning to Asian social capitalism. Specifically this involved replicating Hong Kong’s successful defense of its US dollar peg by accumulating huge capital reserves. Every country in the region accumulated vast troves of US financial assets as a reflection of financial repression. This became the benchmark for success, rather than continuing down the path of liberalization, investing in better education systems, or other policies that would have enriched the citizenry.
But mercantilism hasn’t been great for Asia’s economies. It took Japan forty years to finally turn the corner from its 1980s boom and bust. China is now grappling with many similar problems as Japan, and likely faces a structural decline. But Beijing has been willing to sacrifice per-capita wealth in favor of subsidizing its manufacturing, tech and export base. Japan also pursued financial repression but from a larger economy that made room for its consumers.
Some observers in the West such as Paul Krugman recognized the financial aspect of mercantilism as a ‘savings glut’, which encouraged deflationary exports from Asia and the hollowing of Western manufacturing. Companies and banks in the West responded through increased debt and the use of financial engineering to juice returns. But Napier says the savings-glut arguments missed a fundamental point: the glut was the result of Asian manipulation of exchange rates, a breach in the supposed open, rules-based world trading order. The West ignored this violation until it was too late to change Asian behavior.
Napier says Western acquiescence to this arrangement amounts to an epic policy mistake. But the negotiations and arguing over a vision for the post-Bretton Woods world was too difficult, and US companies were happy to make short-term profits offshoring production to Asia or chasing the emerging Chinese consumer. I’d also note that the US was happy to offshore the environmental costs of manufacturing to cheaper locations as well, while its services industry flourished. Falling interest rates in the US were designed to accommodate this new demand for US financial assets. The US stock market soared. Cheap credit underwrote the subprime mortgages that led the Atlantic world into disaster.
The Asian model of capitalism survived the Asian financial crisis, Napier says, but it wasn’t so much a truce as a new parasitic relationship. No one in New York or Washington asked for China or Thailand to amass huge reserves of Treasury bonds, and no one in Beijing or Bangkok sought permission. The effect was to cost the West its industrial power while saddling it with unsustainable debts.
Napier’s work is a good complement to that of Matthew Klein and Michael Pettis, Trade Wars Are Class Wars. But it can’t cover everything. Napier’s biggest gaps are in the role of technology. He points to the Chinese devaluation of the renminbi in 1994 and the dead-end arguments in 1998 as the sources of the West’s current predicament. I could go back to the early 1970s when US semiconductor manufacturers began offshoring to Asia. This time coincides with the birth of electronic trading. Tech, financialization, and outsourcing manufacturing to Asia were all born in that era, with Nixon’s termination of the Fed’s gold window the enabling piece of the puzzle.
If Bretton Woods was now over, though, this hodgepodge of globalization – foreign capital, labor outsourcing, and tech’s further abstraction of value from production – was hard to define. It felt pretty good in the West, with the end of the Cold War (another missing piece from Napier’s book) convincing policymakers and investors that things were on the right track. It was the turmoil of 1990s emerging-market crises that finally brought trouble to American shores, when the hedge fund LTCM went bust trading options on the Russian ruble, precipitating a Fed-engineered bailout. Thus was born the ‘Fed put’.
This is the true legacy of the AFC: the embrace of moral hazard in the West and the ascent of techno-financial capitalism in which the government stands ready to forgive the mistakes of London, Manhattan and Silicon Valley with taxpayers’ money – and suffer the political consequences of a disaffected populace.
Russell Napier, “The Asian Financial Crisis 1995-98: Birth of the Age of Debt”, Harriman House: London, 2021, 391 pages.