The East Asian Model and the Currency Crisis: Credit Policy and Mundell-Fleming Flows

THE EAST ASIAN MODEL AND THE CURRENCY CRISIS:CREDIT POLICY AND MUNDELL^FLEMING FLOWS

byRAUL V. FABELLA*

University of the Philippines School of Economics

We attempt a story that accounts for both the East Asian crisis andthe East Asian success that preceded it. A two-sector growth model ofa small semi-open economy is proposed, which re£ects most of thefeatures of the so-called East Asian model: a pegged exchange rate, aregulated capital account and a developmental state wielding tightmonetary and credit policy (including credit rationing) to allocateresources towards maximizing export growth and capital accumu-lation. This means capital starvation for most of the non-tradablesector. Singular success and the end of the Cold War induced politicaland economic liberalizations in the 1990s which raised real wagesand threatened growth. The deregulation of Mundell^Fleming £owsappearing as the least politically costly response to changing com-parative advantage induced easy money and endogenized creditallocation which promptly ¢nanced asset price imbalances in favour ofnon-tradables. The latter dictated the allocation of borrowed resourcesthat made the ¢nancial crisis inevitable. We argue that the currencycrisis presents East Asia with an opportunity a© la Olson upheaval toreturn to its roots, a path that Taiwan has taken and one which the USTreasury and the International Monetary Fund will have none of.

" Introduction

In 1993, the World Bank published The East Asian Miracle: EconomicGrowth and Public Policy, at once an unabashed accolade to the economicachievements of the East Asian region and a bold attempt to encompassthe emerging East Asian consensus. In 1997, the ground seemed to havecollapsed from under the region with the East Asian currency crisis. Thisturn of events triggered a rising tide of erudite diagnoses from the mostprominent minds of the economics profession. The lively re-examinationof the East Asian miracle has not counted out the possible demise of theEast Asian model.

While capital account liberalization in di¡erent guises was clearly aubiquitous presence in the various currency crisis stories proposed (see,for example, Davies, 1998; Greenspan, 1998; Krugman, 1998), theInternational Monetary Fund (IMF) insists that capital account

ß Blackwell Publishers Ltd and The Victoria University of Manchester, 1999.Published by Blackwell Publishers Ltd, 108 Cowley Road, Oxford OX4 1JF, UK, and 350 Main Street, Malden, MA 02148, USA.

475

The Manchester School Vol 67 No. 5 Special Issue 19991463^6786 475^495

* I would like to thank E. de Dios, M.C. Gochoco-Bautista, Joseph A. Lim and the BritishCouncil Link Project participants for fruitful discussions. Comments by two anonymousreferees were very incisive and changed the texture of the paper. Errors are mine alone.

liberalization is the wrong tree to bark up. In a remark at an IMFseminar on capital account liberalization Camdessus (1998) claimed that`their [Thailand, South Korea, Indonesia] di¤culties arose from themacroeconomic environment and international setting in which theyopened their capital accounts and the way in which measures to opentheir capital account were sequenced with other reforms'. The problem,therefore, was with the East Asian economies themselves: (i) a domesticbanking system subject to weak supervision, poor prudential standards,and lax internal management; (ii) the inadequacy of timely informationon current economic and ¢nancial conditions; (iii) reforms which did notfollow best sequencing practices; (iv) institutions that were subject topolitical in£uence and networks that enshrined absence of accountabilityas standard operating procedure (see also Fischer, 1998). Is the EastAsian crisis the rigor mortis of the East Asian model?

The conundrum is that (1) these very same `£awed' institutionsdelivered phenomenal crisis-free growth to the region for 15 years in theAssociation of South East Asian Nations (ASEAN) and for the last 35years in East Asia! What was absent at that time was, among other things,capital account liberalization. Direct foreign investment (DFI) was allowedbut it was always regulated. Of course, Hong Kong and Singapore are theexceptions, but these two countries' business as ¢nancial centres being¢nancial intermediation, they are as di¡erent from the rest of East Asia asthe moon is from the sun. By contrast, (2) Taiwan and mainland China, twocountries that publicly opposed rapid capital account liberalization, havelargely escaped the crisis (The Economist, 25 April 1998). (3) Mexico whichembraced capital account liberalization also collapsed in 1994^95 but Chile,which did not and de¢antly so, escaped the tequila e¡ect. Indeed, these seemvery telling. But what are they trying to tell? To frame the answer, we ¢rstneed to model the East Asian miracle.

The outstanding features of the East Asian economies are, byconsensus, sustained rapid growth over the last three decades, very rapidgrowth of exports (and imports) and an ever improving distribution ofincome (see for example World Bank, 1993; Lau and Wan, 1994; Bruno,1996). There are other features that have also attained the status of`stylized facts': (i) a very high savings rate manifested in the perennialtendency to produce a current account surplus; (ii) a phenomenally highinvestment rate which some observers consider the engine of East Asiangrowth (rather than exports, claims Rodrik, 1995) and, being subject tothe law of diminishing returns, will not be sustained (Krugman, 1994;Young, 1994); (iii) superior macroeconomic performance even throughturmoils in the world economy (the two oil price shocks in the 1970s andthe debt crisis in the 1980s; see, for example, Bruno, 1996) as re£ected bylower in£ation and ¢scal balance; (iv) associated with (iii), an inter-temporal bias in favour of future consumption manifested by high real

476 The Manchester School

ß Blackwell Publishers Ltd and The Victoria University of Manchester, 1999.

average interest rates; (v) the employment of credit market micro-interventions such as deposit rate ceilings (Hellman et al., 1996), creditallocation or directed credit (Hayami, 1996) to favour tradable-sectorphysical investment and export promotion at the cost of capital starvationin the non-tradable sector by an activist pro-growth governance (Amsden,1989 (Korea); Wade, 1990 (Taiwan), The Economist, 25 April 1998); (vi)the tendency to emphasize infrastructure and rural development (Aoki(1996) uses the phrase `rural-inclusive development'; Hayami calls itàgricultural fundamentalism') before urban development, and tradablesbefore non-tradables; (vii) a greater political cohesiveness and consensusover economic goals fostered perhaps by rapid growth, by Asian norms(Kapur, 1991), more equal income distribution (Alesina and Rodrik, 1994;Persson and Tabellini, 1994), greater opportunities for wealth creation invalue-adding as opposed to rent-seeking (Bruno, 1996; Hayami, 1996)under predictable rules, and contestable politics.

While there are innumerable models of East Asian growth based onparticular viewpoints (e.g. technology and human capital (e.g. Lucas,1993); governance and the state (e.g. Wade, 1990; Campos and Root,1996)), a model that combines the known stylized facts of East Asiangrowth and features specially associated with the East Asian crisis is sorelymissing. The East Asian crisis embraces many aspects of which our focuswill only include the new emerging facts in the 1990s such as the end of theCold War and the free trade blocs, the political, trade and capital-relatedliberalizations, the ubiquitous presence of asset bubbles in non-tradedsectors and the explosion of domestic credit and foreign liabilities. We willtouch corruption and cronyism only obliquely. Our main policy focus isthe deregulation of Mundell^Fleming type capital £ows.

In Section 2 we give a heuristic discussion of the decision environmentfacing policy-makers in the 1990s and why the capital account wasliberalized further to encompass interest-rate-sensitive Mundell^Fleming£ows. We argue that, among many policy responses to the wage explosionin the 1990s, capital account liberalization promised the least bumpyshort-run economic and political ride. We argue further that the currencycrisis despite the heavy toll can be viewed as an episode of renewal andrea¤rmation of the East Asian model rather than a prelude to its demise.In Section 3 we construct a growth model with two sectors that integratesthe stylized facts of East Asian growth with features and policies thatachieved prominence in the crisis. We argue that a regulated capitalaccount liberalization with regard to interest-sensitive (Mundell^Fleming)£ows was a cornerstone of the East Asian package. In Section 4 we discussthe e¡ects of various political and economic liberalizations and the wageexplosion in the 1990s and the possible model-consistent policy responses.In Section 5 we incorporate, as yet another response, the deregulation ofMundell^Fleming £ows and deduce its implications in asset price

The East Asian Model and the Currency Crisis 477


imbalance and ¢nancial overleveraging. In Section 6 we argue that thecrisis puts East Asia on the crossroads of either returning to its roots orbowing to the IMF's prescription.

á The East Asian Drama: a Heuristic Account

The original East Asian model of growth centred on a conscious e¡ort byan activist governance to anchor economic growth, and in particular growthin tradables (the sector closest to the East Asian notion of industrializa-tion), on maximum export growth. With the exchange rate ¢xed at someinitially high level (i.e. initial undervaluation after an initial devaluation),this export push is achieved by way of low domestic in£ation pursued via aconservative monetary policy which also economizes on the use of scarcecapital. In East Asia this was often supplemented by credit rationing. Thereason is simple: with interest rates high, (a) many worthy capital-intenisveprojects are not viable, and (b) moral hazard with tight credit leads to aStiglitz^Weiss deterioration of bank portfolios as only risky projectsborrow. Thus, credit rationing meant high average interest rates with somefavoured sectors (manufacturing and infrastructure) getting credit rela-tively cheaply, presumably at or near the (world) market rate, with others,namely the non-tradables, getting it at the higher rates. The relatively highe¡ective interest rate facing most non-tradables embodied an implicit taxon negative externalities associated with bubbles. This overall tight moneywith low in£ation strategy maintains a domestic terms of trade favourableto the tradable sector and bottles the bubble tendencies in the credit-starvednon-tradable sector. The high average domestic interest rate in turn issustained by a heavily regulated capital account. With initial labour abun-dance, export growth depended not only on the domestic terms of trade(real exchange rate) but also on the real wage. Low in£ation has thedrawback of a growing real wage when the nominal wage is rising. Thelatter was kept in check by initial labour abundance and labour marketregulations. The original East Asian model thus formed a consistent set ofpolicies that delivered rapid export and income growth with improvingequity along the Stolper^Samuelson logic. But this was at the expense of thenon-traded sector, especially the banking and services sectors, which weretreated as mere appendages of the tradable sector. The e¡ective interest ratefacing the credit-starved non-traded sector was very high.

In the 1990s, the amalgam of political liberalization and labourscarcity led to the explosion of nominal wages. Real wages shot upwardsas in£ation lagged behind. This threatened the capacity of the modeldesigned initially to feed on labour abundance to sustain growth. Thepressure to liberalize trade coming from the World Trade Organization(WTO) and partners could no longer be contained. With the rest of the lessdeveloped countries (LDCs) opening up and competing (notably China),



and the world economy stagnant, a drastic export growth slowdownseemed to be likely. The buzz phrase in East Asia was `higher value-addedexports'. The problem was ¢nancing.

The response within the model itself should have been exchange rateadjustments. Thus, exports would continue to provide the ¢nancing ofexport upgrade. This ran ¢rst into two problems.

(i) Internal: the domestic constituency against eroding wages wasgrowing with the swelling of the middle class newly enfranchised bypolitical liberalization. This also put into serious question the capacityto maintain a real devaluation in the face of the sharpened militancyof labour unions exempli¢ed by the Hyundai strike in late May 1998.

(ii) External: with the record of export success of East Asia, an upwardexchange rate adjustment would appear predatory to developedcountries who were already protesting about trade de¢cits and,being in recession, would have reacted unfavourably. As it was,an appreciation of East Asian currencies was being demanded.The emerging social contracts were therefore unfavourable todevaluations.

In addition, the contest for DFI, itself an upgrade ¢nancing strategy,was intensifying and domestic markets were an important attraction.Devaluation immediately taxes DFI, especially domestic-market-orientedDFI. Furthermore, the new breed of DFI in the 1990s was more eager tosell to than to export from East Asia, given rapidly rising wages. The1990s also saw a new globalist perspective emerge among developedcountries' banks and mutual and hedge fund houses. These were justi¢ablyvery bullish on East Asia, mesmerized by decades of solid growth andenviable macro fundamentals and enticed by emerging risk-reducingderivative instruments spearheaded by so-called `country funds' (e.g.Mexican `tesebonos'). Barred from exchange rate adjustment, the statecould also have borrowed for the ¢nancing of higher value exports toreplace labour-intensive exports. The latter required resources exceedingeven the remarkable East Asian domestic savings. But state-sponsoredborrowing became less acceptable in the 1980s when the foreign debt crisispoisoned the development landscape. Finally, the economy could havegradually eased up credit, risking asset price bubbles in the non-tradedgoods sector and ¢nancial crisis, as happened in Taiwan. But as long as noforeign in£ows take part, a currency crisis is remote. Taiwan also had hugereserves to ¢nance the scaling of the export ladder.

Why not open the capital account? Here was a seeming panacea thatcould sustain growth while skirting all the immediate political problemsrelated to price-mediated adjustments. After more liberal DFI and buildôperate^transfer, the deregulation of Mundell^Fleming £ows, i.e. short-term capital and private foreign borrowing which are interest rate



sensitive, seemed only natural. The con£uence of high average domesticinterest rates, stable currencies and willing creditors produced a £ood offoreign exchange in£ow just as the East Asian tradable sector wasexperiencing a competitiveness thaw. Furthermore, and more importantly,the very structure of East Asian credit strategy meant that the e¡ectiveinterest rate facing the non-traded sector was much higher! The £ood,allowed by unprecedented mobility, thus concentrated on the under-developed and credit-starved non-traded sectors which were prone todemand-led asset price bubbles.

Notwithstanding the bubbles, the deluge sustained rapid incomegrowth while maintaining low or even dipping in£ationöa veritable non-in£ationary expansionary monetary policy! The implicit social contractsremained unscathed while the attractiveness to DFI and the capacity to¢nance higher value-added exports only improved.

Meanwhile, the nominal exchange rate was allowed to appreciate inthe face of the in£ows (a common feature of the so-called volatility bands)resulting in further erosion of the tradable sector. This was due to, amongother things, an asymmetric interest group formation that favoured a cur-rency appreciation and a misplaced inclination of monetary authorities forthe disin£ationary e¡ect of a currency appreciation. This exacerbated agrowing trade and current account de¢cit ¢nanced by in£ows, while theunhedged foreign exchange exposure of the private sector was alsogrowing. The situation was fast becoming a well-camou£aged set-up for afall. While the original (also called `¢rst generation' (Krugman, 1998))indices of macroeconomic fundamentals (namely, in£ation, ¢scal balance,balance of payments) did even better, few noticed that their relevance wasevaporating. The collapse was only a matter of time.

With the onset of the currency crisis, survival became the nationalconcern and suddenly the old social contracts no longer bound. Largedevaluations are now viewed as necessary for survival by both internal andexternal constituencies who previously saw them as irritating beggar-thy-neighbour one-upmanships. We view this development as an Olson upheaval(Olson, 1982) which sweeps away the political gridlock standing in the wayof renewal. It allows East Asia to embrace adjustments that were once closedby internal and external political opposition. It allows the region the optionto return to its roots. The IMF appears, by contrast, to favour recasting EastAsia according to the imperatives of an open capital account.

â The East Asian Drama: the Formal Model

3.1 General Equilibrium Structure with Exogenous Interest Rate

The purpose of this section is to demonstrate how the drive to accumulatecapital induces a tight credit policy in a policy environment that approx-



imates that of the East Asian newly industrialized countries. The modeldoes not attempt to encompass all the compelling features described in theheuristic account but is shown to be consistent with most of them. Themodel's internal consistency breaks down with Mundell^Fleming capitalliberalization.

We construct a model of a small semi-open economy with two sectors:the tradable sector T and the non-tradable sector N. In this paper, we willalso use T and N to represent outputs of the tradable and non-tradablesectors, respectively. T includes manufacturing. N includes prominentlyquasi-tradables such as infrastructure, intermediation industries (¢nancial,distribution, informal) and real estate. N has available surplus labour. Eachsector uses labour and capital and all factors are accounted for. The economyis labour abundant and T is more capital intensive than N. An alternativeuseful characterization of N views the sector as consisting of two segments ofdi¡ering capital intensity, with N's capital to labour ratio being the weightedaverage of the two segments' capital to labour ratios. The capital-intensivesegment, i.e. real estate and banking, is more capital intensive than T; thelabour-intensive segment is more labour intensive than T. No factor reversalis allowed. Finally, the production technology is constant returns to scale.Let k � �KT=L T�, h � �KN=L N�, f �k� be the average output in T, g�h� theaverage output in N, and p � Q=P, whereQ is the price in N andP is the pricein T; the ¢rst-order conditions forP to be amaximumare

f 0�k� � r �1�f �k� ÿ f 0�k�k � w �2�pg0�h� � lr l > 1 �3�p�g�h� ÿ g0�h�h� � w �4�

where w is the wage rate and r and lr are the interest rates in T and N,respectively. We assume that (1)^(4) characterize a locally stable equi-librium. Note that P is inclusive of tari¡s on imports of T. The fourequations can be solved for four unknowns k; h; p and w. This leaves r tobe determined exogenously. Note that p; k; h and w are functions of r.Since r is exogenous, (1)^(4) are consistent with two di¡erent interest rates.Thus, we have a consistent model of an economy where credit policy is apotentially important policy handle. The following results can be derivedfrom (1)^(4) (see for example Obsfeldt and Rogo¡, 1996):

(i) Since T is more capital intensive than N, a rise in r reduces p, i.e.p0�r� < 0, the Stolper^Samuelson relation.

(ii) A rise in p raises N and reduces T for given factor endowments ina full employment setting.

(iii) k0�r� < 0; h0�r� < 0, k0�r� ÿ h0�r� < 0 and w0�r� < 0, the factor pricefrontier slope.



In this case, a rise in r has two e¡ects: the allocative e¤ciency e¡ectmediated by a change in w=r and the revenue e¡ect mediated by a changein the commodity price ratio p. These can con£ict. For example, a rise in r

causes a substitution e¡ect away from capital in both T and N �k0�r� < 0,h0�r� < 0� but, as p falls, it raises the demand for capital in T and lowers itfurther in N (by full employment). We assume the following: the revenuee¡ect of a rise in r exceeds its allocative e¤ciency e¡ect on factor demand.This means that, from L T�w�r�; r; p�r��, we get dL T=dr > 0 since p0�r� < 0,and dL N=dr < 0 for the same reason. The results given by (i)^(iii) areequilibrium results, i.e. one expects them after the economy has settledinto a new equilibrium. These are, in this sense, long-term outcomes.

3.2 Growth Rates

Let T � and N� be the growth rates in T and N, respectively. From theRybczynski proposition, we know that for L � � 0 (which we adopt forsimplicity)

T � � f�L T=K� ��k�r� ÿ h�r��gÿ1K� �5a�N� � f�L N=K� ��k�r� ÿ h�r��gÿ1�ÿK�� 5b�

Let H�r� � f�gÿ1 in (5a) and G�r� � f�gÿ1 in (5b). Clearly H�r� < G�r� if T ismore capital intensive. It is easy to show that H�r� > 1 and G�r� > 1 in(5b). Given L T�w�r�; r; p�r��, we have H0�r� � @H=@r as

@L T

@ww0�r� � @L T

@r� @L T

@pp0�r�

� �Hÿ �k0�r� ÿ h0�r��kÿ h��ÿ1H > 0

since @L T=@p < 0, @L T=@w < 0, @L T=@r > 0 making the expression inbraces greater than zero and, furthermore, kÿ h > 0 and k0 ÿ h0 < 0. Bythe same token, G0�r� < 0. We may thus write for L � � 0

T � � H�r�K� H0 > 0 �6a�N� � G�r��ÿK�� G0 > 0 �6b�

Note that N� is an average tendency. N� < 0 means that the bulk of N (thelabour-intensive segment) is shrinking but the capital-intensive segment maybe growing. Finally, in units of tradables, aggregate income growth is

Y � � gT � � �N� � p��1ÿ g� �7�where g is the share of tradables in Y . Note that we omitted technical progressin (7) for convenience only and not in obeisance to Young^Krugman.Aggregate income growth is the weighted sum of tradable output growth andthe growth of non-tradable output (in units of tradables). The problem is thatthese two outputs react di¡erently to relevant policy shocks.



Let Pw be the world price in T, E the nominal exchange rate and t

the tari¡ rate. If P � EPw�1� t�, i.e. small country, then

p� � Q� ÿ t�

1� tÿ P�w ÿ E� �8�

Since p is a negative function of r; p� is a negative function of r�, and Q�

is a negative function of r�. A fall in r �r� < 0� raises Q� and thus pre-cipitates an asset price movement in favour of N. Likewise, trade liberal-ization �t� < 0� or an absolute currency appreciation �E� < 0� will raise p�.Any other pressure that pushes Q� up will raise p� (e.g. an in£ow of foreignmoney into the demand side of the N market).

Since asset price imbalances have turned up as an important featurein the East Asian currency crisis, it is important to look at what can triggerthem in a semi-open small economy. From (8), currency appreciation,trade liberalization and yen, rinminbi and deutschmark depreciations inthe face of a dollar-pegged E all contribute to growing asset priceimbalance �p� > 0� in favour of N. All these were present in the early1990s in East Asia. But the most important single contributor is the easingup of credit (explosive growth of domestic credit to accommodate capitalin£ows is a common element in the crisis) leading to a rapid rise in Q�

which reached bubble proportions. The consequent rise in p, in turn, im-pacted crucially on the allocation of resources between T and N especiallywhere asset price bubbles in N dominated the landscape. We do not modelasset price bubbles here since our model is an equilibrium model.

Finally, since the real exchange rate RER � EPW=PD where thedomestic price index PD � PgQ1ÿg, g � T =Y , and the world price index PW

is PD's world counterpart, we can write

RER � �PW=Pw�1� t��pgÿ1 �9�Thus, a rise in p leads to currency appreciation.

3.3 Physical Capital Accumulation

The £edgling East Asian economy is assumed for analytical convenienceto possess no capital goods industry of signi¢cance and thus physicalcapital has to be wholly imported. This can be relaxed by assuming a ¢xedfraction of capital growth due to domestic capital. Exports X ¢nanceimports M with the help of the change in foreign exchange reserves DR (aproxy for all exogenous capital £ows, e.g. aid, state borrowing etc.), i.e.M � DR�X. Consumer imports Ic and producer imports IK constitutetotal imports M. Let IK � eM, 0 < e < 0, and e is assumed ¢xed. NowDK � IK ÿ dK or K� � �IK=K� ÿ d, where d is the constant depreciationrate. Thus, K� � �eM=K� ÿ d, and

K� � �e�DR�X�=K� ÿ d �10�



The impact of X on capital growth is mediated by capital import sharee. This in£uence, however, erodes as the capital stock K grows. Theimpact of DR on K� is identical. Thus, foreign borrowing, foreign aidand other exogenous capital in£ows have the same e¡ect on capitalaccumulation.

In view of the debate between Rodrik (1995) of the investment-ledschool and the export-led school of East Asian growth, equation (10)represents the reconciliation school. Let us state (10) formally as

Claim 1: Maximizing exports X maximizes capital accumulation K�.

Thus, no contradiction need arise, but this concordance between the twoengines of growth, if exploited, results in a particular pattern of develop-ment. By (6), this concentrates the focus of growth almost exclusively onT � and away from N�. Before we deal with this, we ¢rst focus on macropolicies that a¡ect X.

3.4 Exports

The tradable output T is either exported �X� or consumed domestically�C�, i.e. T � X� C. Here, C is approximately the output of the importsubstitution sector. Thus

X � T ÿ C �11�

The simple message of (11) sometimes lost to many casual observers isthis: it is pointless to try to expand exports while squeezing T . From(1)^(4), we get T �w�r�; r; p�r�� and the net e¡ect of a rise in r is a rise in T ,i.e. dT =dr > 0.

Now domestic tradables consumption C is a positive function of thereal wage in terms of T �w=P�, and a negative function of the RER:

C � C�w=P;RER� Cw > 0;CR < 0 �12�

where Cw � @C=@�w=P�, and CR � @C=@�RER�. Since the domestic price inT is P � EPw�1� t�, w=P becomes

w

P� w

EPw�1� t� �13�

Rewriting (11) using (13) and (9), we have

X � T �w�r�; r; p�r�� ÿ Cw�r�

EPw�1� t� ;pgPW

Pw�1� t��

�14�

Di¡erentiating (14) with respect to r gives



dXdr� dT

drÿ Cw

w0�r�EPw�1� t��

ÿ CRPW

Pw�1� t� �gÿ 1�pgÿ2p0� �

> 0 �15�

Thus, maximizing K� by expanding exports calls for a high interest rate,i.e. up to a point allowed by the local stability of equilibrium.

Let us call the political preference for rapid capital accumulation thecapital accumulation imperative. What (15) shows is that the capitalaccumulation imperative manifests itself in, among other things, tightcredit policy, i.e. high average r. To state this formally:

Claim 2: The capital accumulation imperative induces tight credit in theEast Asian model.

The rapid capital accumulation in evidence in the East Asianeconomies anchors the capital accumulation interpretation of the EastAsian miracle. What Claim 2 says is that the evidence is consistent with,and may have been induced by, tight credit (and high r) working throughexports.

The tightness of credit has structural and stability limits (not directlymodelled here). Since r is the price of capital, r can be pushed to levels thathurt the export sector itself �X� < 0� and a priori T �T � < 0�. This is thecase of abnormal shocks pushing the system out of equilibrium. That is,an excessively high r can jeopardize the local stability of equilibriumrepresented by (1)^(4) and invalidate the comparative statics results.

The impact of tight credit (within limits) on N is the opposite. A highr raises X which raises K� which, in turn, by Rybczynski, shrinks thenon-tradable output of N �N� < 0�. Therefore, the same instrumentemployed in the service of the capital accumulation imperative to supportgrowth in T serves to hamstring the non-tradable sector. Furthermore, it(higher r) lowers p which shrinks N.

However, tight credit alone is not enough.

3.5 Developmental State

The East Asian economies are many times characterized as blessed withan activist developmental state, speci¢cally, with a bias towards exports.In this stripped down growth model the central policy variable is r (EastAsia pegged E after considerable initial devaluations and t is governed bymultilateral commitments), and the allocation of resources via r is themost important expression of activist governance. The motive for controlof r is to maximize exports which feed K�; T � and Y �. But, in the process,the tight money that maximizes X and K� and keeps the non-traded sector,especially the capital-intensive segment, under wraps (from (6) and the



Rybzcynski proposition) also renders certain necessary but unavoidablycapital-intensive projects unviable if left to the market unassisted. Thecapital-intensive N shrinks with r but expands with capital accumulation!A more compelling consideration is that, with high interest rates, moralhazard results in the deterioration of the quality of bank portfolios a© laStiglitz^Weiss. Credit rationing was the answer.

The East Asian economies, therefore (especially Japan, Taiwan andSouth Korea), went further than simply tightening credit. For certain verycapital-intensive sectors of N (power generation, telecommunicationsetc.) which are necessary for T (may indeed be labelled quasi-tradables), itwas necessary to ease credit. Credit was made available cheap for thosesectors which purportedly bestowed substantial `dynamic externalities' tothe rest of the economy. They became wards of the state whether asparastatals or favoured private projects. This credit rationing resulted inthe credit starvation of disfavoured segments of N. Thus, an overall tightcredit was supplemented by and indeed required credit rationing to favourcertain segments of T and N and shackle other segments of the non-tradedgoods sector. This ¢nancial dirigisme led to a backward intermediationsector (bad) but credit starvation also led to reduced frequency of en-counters with price bubbles (good). The higher e¡ective interest rate facedby the neglected N segments embodied an implicit tax against the per-ceived negative externality associated with asset price bubbles and theiradverse e¡ect on income distribution and resource allocation. Interest ratenon-parity became the permanent state of a¡airs.

The reason that monetary policy can target export growth despitethe pegged E is that the capital account is regulated especially as regardsMundell^Fleming type (interest-di¡erential-sensitive) £ows. If Mundell^Fleming type £ows are deregulated, capital £ows in because of interest ratenon-parity and the economy loses monetary independence under a peggedE. As a result, the dirigiste credit governance, manifested as creditrationing in the face of overall easy credit, becomes distortive and harmful,robbing the East Asian model of its unique £avour and more importantlyits consistency.

Credit rationing and ¢nancial dirigisme, however, can easily lead tocronyism and corruption. The temptation to ration resources in favour offriends and family is very grave and, indeed, broke many people's resolve.The risk of this happening, however, is diminished with overall tight creditand when the favoured sectors are operating under relatively competitivemarket discipline, e.g. exports.

3.6 Consistency with Stylized Facts

The East Asian push for exports via tight credit had other salutary e¡ectsapart from rapid export and income growth. It meant lower in£ation and



a more stable implicit contract with labour, whose real wage was growing.It also meant that bubble tendencies in the non-traded goods sector, aprincipal cause of boom-and-bust cycles in most LDCs, had littleroom to manoeuvre (this being normally provided by easy credit), andeven less room to generate fabulous speculative capital gains. This, inturn, meant greater room for value-adding as opposed to rent-seekingactivities (Hayami, 1996).

In sum, the East Asian model presented here consists of (i) a peggedexchange rate; (ii) a regulated capital account with regard to Mundell^Fleming type capital £ows, i.e. interest di¡erential sensitive; (iii) an activistdevelopmental governance which deploys tight monetary policy (high r)to favour labour-intensive export growth and thus physical capital invest-ment, and credit rationing to nurture very capital-intensive quasi-tradablesand keep at bay bubble-prone non-tradables; (iv) a domestic averageinterest rate r higher than the world interest rate (given both labourabundance and purposive tight money), with the e¡ective interest rate rNfaced by the unfavoured non-traded goods sector being much higher thanthe world interest rate; and (v) a relatively underdeveloped intermediationsector (Japan being the prototype where the keiretsu usually has its ownbank to provide credit) with credit allocation being heavily in£uenced by a¢nancial dirigiste state.

Many interesting aspects of the East Asian economy clearly lieoutside this model framework. We will argue, however, that these aspectsare consistent with tight credit policy. Some of these are a decreasingincome Gini ratio, ¢scal prudence, high savings and high investmentrates.

This East Asian model is consistent with a decreasing income Giniratio. With emphasis on exports, the price of labour-intensive goods isgiven a boost in the world market. By Stolper^Samuelson, the w=r willeventually rise, blunting the initial tight money e¡ect. High in£ation andunemployment, the most important contributors to poverty, are avoidedas the economy settles on a non-in£ationary rapid labour absorption pathconsistent with HeckscherÔhlin specialization.

The tight money policy blocks the monetization of ¢scal de¢cits,which means that these can only be ¢nanced by borrowing from theprivate sector, rendering it at once very costly, non-in£ationary andunattractive. This adds urgency to better tax e¡ort and ¢scal conservatism.Superior macroeconomic indicators follow.

The high average interest rate also induces a marked preference forfuture consumption and thus could help raise, but certainly not dis-courage, the savings rate (e.g. Taiwan). The repression of N via high r

(and via credit rationing) results in a drag on urban development which isdemand-driven and thus highly credit-elastic. The high interest rate, bycontrast, is not a drag to rapid investment in labour-intensive T as long as



other factor prices are low and credit allocation renders capital cheap tothe quasi-tradable segment of N. This only redirects investment to exportswhich economizes on the use of capital (the price HeckscherÔhlin^Samuelson proposition sees to it that the larger di¡erential in w=r trans-lates into a wider di¡erential in goods price) which works all the better forlabour-intensive exports. In a closed economy, a high r that chokes o¡domestic demand will choke o¡ investment and the investment rate willnormally be low. But with T and exports, domestic demand was never thecrucial issue.

The East Asian model was not geared to domestic demand-ledgrowth, precisely because it was outward oriented. Japan is the primeexample where internal demand stimulus via easy credit only created abubble economy but has so far failed to quicken the post bubble economicpace. As long as the focus of growth is on T, the world market with itsups and downs takes care of demand. As we shall see, the developments inthe 1990s shifted the strategy partly towards domestic demand-drivennon-tradables growth.

This package of policies and circumstances was internally consistentand has delivered phenomenal export and income growth to East Asiaover the last three decades. By contrast, countries that deliberatelycheapened capital (general easy credit) in the name of import substitutionexperienced higher in£ation, slower growth of exports and income, andperennial rendezvous with asset bubbles and balance of payments crises.

The very success of the East Asian model enticing a train of LDCemulators and the changing comparative advantage in the 1990s was,nevertheless, beginning to depress growth potential. The East Asian econo-mies were coming to a fork on the road of a phenomenally successfuldevelopment.

ã Liberalization and the Real Wage in the "ññòs

4.1 Liberalization

The 1990s ushered in new realities that required deep adjustments. Afterdecades of export-led success, labour scarcity became the norm in EastAsia. The WTO^GATT and the emerging free trade blocks pushed tradeliberalization to breakneck speeds. Finally, political liberalization, thanksto the collapse of the Soviet bloc and the end of the Cold War, led to anemerging middle class with considerable political in£uence.

The impact of these on export growth can be gleaned from (14).

(i) Trade liberalization in East Asia induced by GATT^WTO and theemerging trade blocs implied lowered t. Since intermediate inputimports for use in the production of exportables were already almosttari¡-free by the end of the 1980s (via duty drawbacks and bonded



warehouse schemes), the impact of lowered t fell largely on realwages. This also raises p (see (8)) which induces a crucial investmentallocation e¡ect.

(ii) Emerging labour scarcity began in the 1970s among the Asian tigersbut, combined with political liberalization in the 1990s, meant anominal wage explosion, in the face of lagging in£ation.

(iii) Political liberalization created a constituency against any erosion ofnominal income through in£ation. This made certain policy responseswithin the East Asian model unpalatable.

(iv) The exchange rate peg to the US dollar in combination with (a) thedepreciating yen, pound sterling and deutschmark and (b) the entryof and currency devaluation in China and Mexico meant e¡ectivelylower PW and lower EPW which, in turn, caused currency appreci-ations all over East Asia. Likewise, p� rises with E� < 0 (8). Thismeant an increased pressure for a £ow of resources from T to N. Allthese in the end meant a lower X� on the horizon as well as lowerT � and thus Y �.

4.2 Model-consistent Responses

The wage explosion and threatened slower export and income growthwould have triggered model-consistent responses. One response was justplain exchange rate adjustment. A higher E would have mitigated,though not wholly eliminated, the impact of these developments in the1990s. It would have stemmed the erosion of RER by lowering p. Thepersistent clamour from Korean industries for a downward exchangerate adjustment since 1990 is well known and largely re£ects this. Thesecond response was state borrowing from abroad to ¢nance thetransition to higher value-added exports. This second option becameanathema in the 1980s. The ¢rst option meant higher in£ation and theerosion of purchasing power in terms of T and thus faced sti¡ internalopposition from the emerging middle class while it ran roughshod overdomestic-market-oriented DFI. The capacity to e¡ect and maintain areal devaluation was also questioned. Moreover, upward exchange rateadjustment (i.e. depreciation) was viewed with suspicion by OECDcountries that had been losing jobs to East Asia, and East Asianmonetary authorities tended to be very sensitive to US and EUobjections. Thus, internal and external implicit social contracts workedagainst the adoption of these two model-consistent responses. Finally, athird strategy involved the deployment of accumulated huge foreignexchange reserves to ¢nance the growth in the transition period towardsa mature economy while gradually easing up credit to motivate capitalintensity further. This necessitated the continuing regulation of capital£ows. Taiwan took the third path.



ä Deregulation of the Mundell^Fleming Flows

5.1 Impact E¡ects

East Asian authorities (especially those whose reserves were low) soonrealized that there was a fourth and `painless' solution to the problem. Thegrowth of income can be sustained despite the real wage explosion withoutcourting in£ation and adverse political fallout. This involved no more thana central bank memorandum allowing free movement of short-term capitaland allowing either private banks (South Korea) or companies or both(Thailand, Indonesia and the Philippines) to contract dollar debt at verylow world interest rates. The aversion to state foreign borrowing did notapply and this needed no di¤cult passage through the newly assertivelegislative mill.

This is factored into the model by appending into the balance ofpayments equation a Mundell^Fleming net capital £ow F, i.e. M �DR�X� F. Note that F is used to ¢nance either a trade de¢cit or a risein foreign exchange reserves. We get the analogue of (10):

K� � e�DR�X� F�Kÿ1 ÿ d �16�Capital accumulation now partly ¢nanced from F is subject to anyvolatility associated with F. It is also probable that the share of physicalcapital imports e may have fallen with F, i.e. e�F�, e0 < 0. We know that F

is a positive function of the interest rate di¡erential �rÿ rw�, i.e. F�rÿ rw�,F0 > 0 and F�0� � 0. But now r itself falls with F (see Gochoco-Bautista,1998). Let

r � Zÿ BF �17�where Z is a function of the monetary aggregates used. Thus, if rÿ rw > 0is large initially, F is large and K� will rise or be maintained by (16) even ifX is stagnant. This means that by (6a) there is not only continued buoyancyin T, but even more buoyancy for the capital-intensive segment of N. Thismay have been the logic behind the opening up. However, p rises as r falls.This terms of trade e¡ect squeezes T and expands N. The £ow of newinvestment shifts towards N. The overall e¡ect is an expansion of N andthus, by (7), a sustained or even a rising Y � which, ex post and in the shortrun, justi¢es capital liberalization. But now Y � is also subject to the volatilityof F.

The secondary e¡ect is also interesting. Note that, as long as F > 0,r is falling and p is rising, re£ecting a rising asset price imbalance. In EastAsia, N was visibly expanding in the 1990s as a response to p rising.

5.2 Model Consistency

With liberalized Mundell^Fleming £ows, the authorities lose control of r.



A higher r induces higher F. The interest rate begins to fall by (17). Whatis more, what was originally a limited or rationed easy credit (for thosetradables or quasi-tradables with access to foreign credit) became trans-formed into easy money for all as banks were subsequently allowed toborrow outside. The credit-based developmental state (at least in thispaper) now wields a set of policies which is inconsistent but may persistfor political reasons. A leveraged consumption boom (e.g. of importedcars) may accompany the boom in the non-traded sector as interest ratesfacing households fall.

The con£uence of trade liberalization, the domestic currency appreci-ation due to dollar appreciation and E� < 0 forced p� higher. F itself beginsto £ow increasingly into N where rN is very high. This raises the uncoveredexposure of banks and borrowers. The `magic' of euphoric asset bubblesbeing that debts are wiped out on paper as quickly as they are incurred,the maturity of the debt becomes irrelevant. This leads to a rise in foreigndebt of shorter maturities. A crisis was only a matter of time.

Would £oating the exchange rate have avoided the problems associatedwith deregulating Mundell^Fleming £ows? With other macroeconomicindicators (prices, foreign exchange reserves, ¢scal balance) looking sogood, the danger of a depreciation with a £oat would have been ignored andin£ows would only have triggered even larger appreciations which, in turn,would have exacerbated the problem.

What if neither Mundell^Fleming deregulation nor a devaluation hadbeen adopted? The most likely path is the Taiwan route (The Economist, 25April 1998): gradual easing of credit which created a property bubble inthe late 1980s. But note that this did not result in a currency crisis when itcollapsed precisely because F was not allowed to participate. Growthgradually slows down as the economy closes the catch-up phase and entersthe mature economy stage (see also Lau andWan, 1993), even if a successfultransition to higher value-added exports is negotiated.

5.3 An Olson Upheaval?

The bubble collapse and currency crisis in East Asia rendered the emergingsocial contracts non-binding. Suddenly survival was the issue and theconstituencies behind a stable currency and low in£ation lost theirin£uence. Large devaluations that in the past were rejected as in£ationaryby implied social contracts became politically acceptable. The in£ated realwages were suddenly undermined. Furthermore, the major trading part-ners would hardly interpret these as predatory and job-stealing actions.Their attention suddenly shifted from peripheral low skilled job losses (inEast Asia) to threatened general job losses in the event of a developedcountries' output slowdown if East Asia spun out of control. The currencycrisis, by undermining internal and external socio-political opposition to



exchange rate adjustment, gives East Asia the option to revitalize its exportengine along the original East Asian model framework. The crisis can beviewed as an Olson upheaval (Olson, 1982), which shatters the existingcontracts and allows the social system room for self-renewal.

East Asia stands at the crossroads. It either returns to its roots, oncemore regulating Mundell^Fleming £ows and following in the foosteps ofTaiwan, or it recon¢gures itself completely to satisfy the imperatives of anopen capital account. The latter is the route preached by the US Treasuryand the IMF. Of course, all the bulging pockets of fund and portfoliohouses are likewise arrayed.

What, however, is the nature of the return option? Clearly, theworld at the turn of the century is very far removed from the world thatspawned the East Asian successes. The return option is di¡erent forcountries depending on their catch-up stage. The catch-up era is closingfor Taiwan and South Korea. For these two countries, the imperative isfor a gradual and properly sequenced transition to maturity. This, how-ever, will still require continued regulation of Mundell^Fleming £ows.For other LDCs still deep in the catch-up struggle, the East Asian modelremains a peerless growth paradigm. Proper sequencing of adjustmentsto a changing environment needs to be observed. The model, championedby the US Treasury and more guardedly by the IMF and the World Bank,one which holds sacred the free mobility of all capital, is untested anddangerous.

å Summary

A growth model of a small semi-open economy in the HeckscherÔhlin^Samuelson tradition has been proposed with properties that mimic closelythe stylized facts of the East Asian economy: a pegged exchange rate, aregulated capital account, a developmental state wielding conservativemonetary and ¢nancial policy (supplemented with credit allocation) tomaximize export and investment growth. The model is consistent withrapid income growth hand-in-hand with a falling income Gini ratio, a highsavings rate, superior macroeconomic fundamentals, a marked bias infavour of future consumption, a preference for the tradable sector in creditallocation resulting in relative underdevelopment and capital starvationin the non-traded and intermediary sector.

The 1990s ushered in internal and external developments thatthreatened the remarkable performance of the East Asian economies:exploding real wages followed the political liberalization brought aboutby the end of the Cold War; goods trade liberalization and deregulationin the wake of WTO; the emergence of regional trading blocs; theemergence of China and other low wage rivals; the depreciation of theyen, deutschmark and renminbi; ¢nally, Japan's continued inability to



grow after the collapse of its bubble economyöall conspiring to squeezeexports, tradable sector vitality and future income growth.

The policy responses within the model itself consisted of either (i)exchange rate adjustment to mitigate the impact of increasing cost ofdomestic factors and maintaining the edge of the tradable sector over thenon-tradable; or (ii) state-sponsored borrowing from abroad to ¢nance thetransition to higher value-added exports. The latter became anathema inthe 1980s when the state foreign debt crisis poisoned the developmentlandscape. The former would erode income in terms of T and scare awaydomestic-market-oriented DFI. Furthermore, OECD trading partnersviewed it with irritation. A third path (iii) taken by Taiwan is to deployhuge foreign exchange reserves to ¢nance the transition to higher value-added exports, hand-in-hand with the easing up of monetary policy toinduce capital deepening and growth in N. This ran the risk of asset pricebubbles in N, and it necessitated continuing the regulation of capital£ows.

For those countries with inadequate foreign exchange reserves, theEast Asian miracle opened up a new avenue. The ¢nancial houses thatdeployed capital of the Mundell^Fleming variety were attracted to EastAsia's high domestic interest rates. A deregulation here accompanied byautomatic convertibility brought a £ood. In view of the credit starvationand higher e¡ective interest rates in the non-tradables sector, on the onehand, and the eroding comparative advantage of tradables on the other,the massive in£ows went to the non-tradables sector, which could nolonger be directly controlled by the state. Likewise, it forced the rapideasing up of credit, which further favoured the non-traded goods sector.The East Asian package of policies became inconsistent and its perennialbenign neglect of the intermediation sector became glaringly obvious.Meanwhile, the so-called `¢rst generation' indices (in£ation, ¢scal balance,foreign exchange reserves) all did very well. It was a set-up for a ¢nancialand currency crisis.

The East Asian model was clearly dragged down by the rapidderegulation of Mundell^Fleming £ows. The aftermath of the crisis,however, made one model-consistent response, i.e. a large devaluation,politically feasible and allowed East Asia the option to partly return to itsroots. The IMF and its Wall Street allies would rather see East Asiarecon¢gure itself according to the imperatives of an open capital account.The battlelines are drawn.

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Documents

The East Asian Model and the Currency Crisis: Credit Policy and Mundell-Fleming Flows