Sheng, Andrew

English

Research Papers in Economics

115
Anne Krueger has provided us with an authoritative analysis of the Asian finan-
cial experience, particularly focusing on the Korean and Japanese experiences 
that are common to the 1997–98 Asian crisis and the current global crisis . She 
has drawn on a wealth of recent papers and drawn important common lessons, 
divided into four major parts: first, the relevance of rapid growth leading up to 
crisis and the importance of a well-functioning financial system; second, a set of 
lessons relevant mainly for emerging markets; third, key financial sector issues 
from Japan and Korea that are relevant to the crisis economies in Asia; and 
fourth, crisis and post-crisis management issues .
Krueger’s analysis stems from the mainstream of economic analysis, which 
has focused on the importance of well-functioning financial systems, their cap-
ital adequacy, and their contribution to financial stability . Financial systems 
have four important functions that policymakers neglect to their peril: resource 
allocation, risk management, transparency, and corporate governance . Weak-
nesses in any of these functions would contribute to the weakening of the real 
sector, leading to crisis and losses in output and employment .
common lessons for emerging markets
As Krueger has pointed out, financial crises are complex and have many ori-
gins . They all start with prosperity . In the case of Asian countries, they started 
with very rapid growth, policy mistakes, and complacency that led to asset bub-
bles; once the bubbles collapsed, there followed large capital outflows, insol-
vency in the real and banking systems, and losses in output, with huge fiscal 
deficits arising from the rescue efforts .
Among the common lessons for all emerging markets, the first is the need 
for a consistent macroeconomic policy regime, in particular a flexible exchange 
rate regime consistent with fiscal and monetary policies . The second is to avoid 
mismatches between banking assets and liabilities in terms of both maturity 
commenTAry
Lessons from Asian Financial Experience
Andrew Sheng
author’s	note: The views expressed are purely personal and not associated with the China 
Banking Regulatory Commission.116	 ASIA ECONOMIC POLICY CONFERENCE  ASIA AND THE GLOBAL FINANCIAL CRISIS
and foreign exchange (consider, for example, the famous double mismatch in 
the Asian financial crisis) . Third, emerging markets should eliminate financial 
repression after rapid growth and deepen the capital and debt markets . Fourth, 
policymakers and financial regulators should avoid complacency and favor more 
market-oriented policies, because rapid growth and success does not necessar-
ily guarantee future success . Indeed, the 1997–98 Asian crisis affected some 
highly successful countries, not failed economies .
A final common lesson for emerging markets is that immediate, credible, 
and forceful action (such as removal of toxic assets, recapitalization of banks, 
deleveraging of firms, and fiscal stimulus) can result in lower losses, can limit 
the length and severity of downturns, and can speed up and strengthen eco-
nomic upturns .
lessons from Japan
Krueger rightly points out that the 1997–98 Asian financial crisis encompassed 
the prolonged Japanese crisis, which resulted in nearly two decades of low 
growth, deflation, huge fiscal debt, and zero interest rates . Her analysis of the 
Japanese and Korean experiences draws significant implications for the reso-
lution of the current global crisis . As shown in Table 1, Japan was the largest 
economy by far in East Asia in 1996, nearly five times larger than China and 
double the size of the rest of East Asia .
There was a marked difference between Japan and the rest of the East 
Asian crisis economies: Japan had mostly domestic debt and a flexible exchange 
rate, while other countries were accused of pursuing the “impossible trinity” 
of fixed exchange rates, independent monetary policy, and no capital controls . 
TaBlE  1 
GdP of selected countries 
(current exchange rate in USD billions)
  1990  1995  1996  1998  2006
Japan  3,031  5,278  4,638  3,872  4,367
China  388  728  856  1019  2,630
Korea  264  517  558  348  888
Indonesia  126  223  251  105  364
Thailand  86  168  182  111  206
Hong Kong  77  144  159  167  189
Malaysia  44  89  101  72  151
USA  4,268  7,398  7,817  8,747  13,245
Source: IMF data .  SHENG  |  COMMENTARY  |  LESSONS FROM ASIAN FINANCIAL EXPERIENCE	 117
But the Japanese experience was similar to others during the pre-crisis period 
of rapid economic growth that resulted in real estate and stock market bub-
bles accompanied by problematic lending . Like almost all other East Asian 
economies, Japan still has a bank-dominated financial system, and mistakes of 
forbearance, evergreening, and late resolution of bank failures delayed the eco-
nomic recovery .
Indeed, Krueger perceptively pointed out a mistaken policy assumption 
that, if only economic growth were to resume, the debtors would regain profit-
ability and banks would grow out of their nonperforming loans . I suspect that 
this growth assumption persists even in current rescue plans . The Japanese 
experience was one of repeated stimulus packages, with annual fiscal deficits 
of over 5 percent that led the country’s debt to grow to nearly 200 percent of 
GDP . This debt was owed mainly to residents, but was sustainable only with 
zero interest rates .
Krueger shares the common Western view that Japanese reaction to the 
crisis was “too little, too late .” Many of my Japanese friends beg to differ . Their 
difficulty was not a technical issue of how to respond, but how to garner public, 
political, and legislative support for the rescue of banks . Exactly like the reac-
tion of the U .S . Congress, which initially rejected the Treasury’s rescue plan 
in the fall of 2008, the Japanese electorate felt—not without good reason—that 
overpaid bankers got themselves into trouble and should therefore get them-
selves out . Hence, the bank write-offs of credit losses were 19 percent of GDP 
compared with fiscal support of only 3 percent of GDP . But the biggest support 
of banks came through the zero interest rate policy, which gave the banks a 
positive interest rate spread, similar to the current U .S . policy . In other words, 
both the past Japanese solution and the current U .S . solution relied on a guar-
antee of stock and flow bank rescue policy, rather than balance sheet surgery to 
“carve out bad loans .”
Implicit in the Krueger analysis is that an undercapitalized banking sys-
tem can retard an incipient recovery, even when fiscal policy is expansionary, 
and forbearance and evergreening of loans by banks generally lead to disas-
ter . In other words, efforts by banks (and acquiescence by the government) to 
hide their difficulties not only delay recovery but can create uncertainty and 
a lack of confidence about the financial system as a whole . Thus, Krueger sub-
scribes to the “whatever it takes” approach, using sufficiently large measures 
to restore banks to healthy positions . She noted correctly that bank deleverag-
ing starved new entrants (small and medium enterprises) of credit and hence 
reduced growth .118	 ASIA ECONOMIC POLICY CONFERENCE  ASIA AND THE GLOBAL FINANCIAL CRISIS
Post-crisis Policy and management
Based upon the above survey, Krueger draws the conclusion that delays in rec-
ognizing and confronting the difficulties are costly . Crisis management requires 
credibility, built through financial condition transparency and decisive actions . 
There must be consistency between exchange rate, monetary, and regulatory 
policies . She believes that the most important lesson is the need to recapitalize 
banks and address nonperforming loans . As in the case of Japan in the last 20 
years, fiscal stimulus can provide a temporary boost, “but if the financial sys-
tem remains crippled, recovery is not sustainable .”
I agree with the analysis provided by Krueger, but I would like to widen 
her analysis beyond one or two countries and beyond economics to politics, since 
flawed politics are always the root causes of financial crisis . Having been in the 
trenches during the Asian crisis 12 years ago and during the post-crisis res-
olution and reform efforts, I wrote a book, From Asian to Global Financial 
Crisis,1 which was published this year . My research into individual crisis coun-
tries and into the group as a whole showed that, in addition to the commonalities 
identified by Krueger and others, the interactivity and interdependency within 
the region complicated collective action and created dilemmas which led to the 
crisis and hindered the recovery .
The fact that the Asian crisis contagion hit several countries at roughly the 
same time demonstrates that this was a relatively new phenomenon . I call this 
a network crisis, because East Asia networked to form the global supply chain 
with Japan at its head . The main customer was the U .S . market, which explains 
why the global supply chain basically linked to the dollar through either a fixed 
peg or a managed float . Basically, the supply chain required member economies 
to adopt stable parities against each other . I do not justify pursuit of the impos-
sible trinity, but I understand why, for various political reasons, central banks 
were reluctant or unable to exit a previously successful policy and adopt a float-
ing regime . With high dollar-yen volatility, the Asian supply chain was a net-
work with two standards .
Indeed, the analytical framework of a network crisis is useful because it 
gives us a holistic view of the complex, highly concentrated, interconnected, 
interactive/interdependent, opaque financial system with incentives that were 
procyclical and contained highly systemic risks .2 We need this network type of 
analysis because all social institutions, including banks and financial systems, 
are ecosystems, which are dynamic and formed through the interaction of the 
human and bureaucratic behavior of participants .  SHENG  |  COMMENTARY  |  LESSONS FROM ASIAN FINANCIAL EXPERIENCE	 119
ChaRT  1 
Gross domestic Product in constant 2000 us$
-15
-10
-5
0
5
10
15
1
9
8
1
1
9
8
2
1
9
8
3
1
9
8
4
1
9
8
5
1
9
8
6
1
9
8
7
1
9
8
8
1
9
8
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
Hong Kong Indonesia
South Korea Malaysia
Philippines Singapore
Taiwan Thailand
Percent
Source: World development indicators online .
The extensive interdependency between East Asian economies and the U .S . 
can be seen from Chart 1, which illustrates the synchronization of the Asian 
trade cycle . As the saying goes, if the U .S . sneezes, Japan catches a cold, and 
Asia gets pneumonia . This time around, the U .S . has had more than a cold, and 
Japan and the exporting nations in Asia are badly hurt, but due to their health-
ier macroeconomic conditions (partly because they learned from their mistakes 
12 years ago), their recovery has been more marked .
Ecosystems are complex institutions, but to work effectively and stably they 
need simple rules that are easy to enforce . Enforcement shapes the incentive 
structure to ensure stability . However, lack of enforcement against risky or 
arbitraging behavior can build up huge opaque risks and imbalances that ulti-
mately lead to crisis . I liken crisis to warfare because war leads to loss, just like 
financial crisis . To paraphrase German strategist von Clausewitz, substituting 120	 ASIA ECONOMIC POLICY CONFERENCE  ASIA AND THE GLOBAL FINANCIAL CRISIS
“war” with “crisis,” you get, “Everything in crisis is very simple, but the sim-
plest thing is difficult . The difficulties accumulate and end by producing a kind 
of friction that is inconceivable unless one has experienced crisis .”
One of the reasons why everyone failed to detect or prevent the Asian crisis 
and the current crisis is that our academic and bureaucratic disciplines are so 
specialized and compartmentalized that we see only part of the picture, rather 
than linking its parts together .3
For example, most economists still look at flows to explain behavior, whereas 
Nomura’s Richard Koo was the first to point out that the Japanese crisis and the 
current crisis can be labeled a balance sheet crisis .4 This is very evident from 
Table 2, which shows that almost all the crisis economies (with the exception of 
South Korea) had net international debt positions of more than 50 percent of 
GDP in 1996 . If the IMF had emphasized this earlier than 2006, we might have 
been more sensitive to unsustainable foreign exchange imbalances .
Given the fact that the East Asian economies had large banking systems 
relative to GDP and that the banks lent heavily to finance the stock and real 
estate markets, it is not surprising that collapses in the real estate and stock 
markets led to huge losses and undercapitalization of the banking system .
This is one reason high interest rates and cuts in fiscal expenditure were 
clearly the wrong policies to pursue during the early stages of the Asian cri-
sis . High real interest rates would make the overleveraged corporate sector 
more distressed, leading to even larger losses in the banking system . However, 
because of the openness in the capital account, East Asian economies could not 
use higher interest rates for fear of inviting even more hot money that would 
inflate the domestic bubbles even more . In other words, the Asian crisis was 
TaBlE  2 
net International Position (nIP) (+asset/–liability) of Various economies
  NIP 1996  NIP as %   Fall in GDP  Change in exchange  Remarks
  (USD billions)  of GDP, 1996  1997/98 (%)  rate (+/–) 1998/97
Japan  +890 .0  +19 .0%  –8 .5%  –10 .7%
China  –122 .9  –15 .1%  +5 .3%  +0 .2%    Protected by  
exchange control
Indonesia  –129 .4  –56 .1%  –55 .8%  –51 .4%
Korea  –50 .2  –9 .0%  –33 .1%  –50 .2%    Bank run causing  
exchange overshoot
Malaysia  –55 .9  –55 .4%  –27 .9%  –35 .0%
Philippines  –41 .6  –49 .2%  –20 .5%  –34 .2%    Already under IMF   
Program in 1997
Singapore  +80 .2  +87 .0%  –14 .2%  –14 .9%  Contagion effect
Thailand  –101 .8  –55 .9%  –25 .9%  –45 .8%
Source: Calculations from Lane and Milesi-Ferretti (2006) .  SHENG  |  COMMENTARY  |  LESSONS FROM ASIAN FINANCIAL EXPERIENCE	 121
inextricably tied to the policy dilemmas of globalization, in which most coun-
tries were not sure how to create the right blend of policies, given that large 
volatile capital flows (now identified as the leveraged carry trade) could lead to 
excess liquidity and highly distorted domestic sectors .
conclusions
If we accept that financial crises have origins that are complex and are tied 
to the whole range of policies, flawed institutions, and feedback through inter-
action across borders, then we should recognize that their resolution requires 
much better international cooperation than previously thought . In many ways, 
a collective action problem already exists in coordinating the many silos within 
domestic financial systems that regulate financial stability, not least the Min-
istry of Finance, the central bank, the financial regulators, and increasingly 
the influence of the legislature that must approve legal and structural changes . 
Legislatures can protect strong vested interests and may not be willing to 
respond with the speed required at the technical level . These collective action 
traps delay or impede many actions or policies that can be identified at the tech-
nical level, but cannot be enforced or implemented at the political or bureau-
cratic level .
If the collective action problem of coordinating policies is difficult at the 
national level, the difficulties at the regional and global levels are even more 
Herculean . Hence, the biggest lesson that I draw from the global financial cri-
ses is that countries must accept that they have to work together in a complex 
ecosystem with many vested interests that require lots of carrots and sticks 
to get everyone to cooperate for the common good . We have to recognize that 
the greater the complexity of issues, the greater the costs and the difficulties, 
from identification, diagnosis, and prognosis to implementation, enforcement, 
and action, and these can lead to more opportunities for arbitrage, fraud, and 
further distortions that benefit some factions and vested interests . Patchwork 
and partial solutions are more likely to delay real action, a problem identified by 
Krueger during the Japanese crisis .
The only way we can achieve common collective action is through simplic-
ity, sometimes unfortunately through a race to the lowest common denominator . 
If individual countries seek to flee and exit for the door, it may create massive 
panic and large public loss unless prevented by a collective response .
If we do not simplify our financial structures and make the difficult choices 
on which standards to enforce, so that the financial institutions will not exploit a 
massive moral hazard, then we will not have learned any lessons from the past 
and we will be more likely to experience future crises .122	 ASIA ECONOMIC POLICY CONFERENCE  ASIA AND THE GLOBAL FINANCIAL CRISIS
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Koo, Richard . 2009 . “The Holy Grail of Macroeconomics—Lessons from Japan’s Great 
Recession .” Singapore: John Wiley Asia .
Lane, Philip R ., and Gian Maria Milesi-Ferretti . 2006 . “The External Wealth of Nations 
Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970–
2004 .” IMF Working Paper WP/06/99, March .
Sheng, Andrew . 2005 . “The Weakest Link: Financial Markets, Contagion, and Networks .” 
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Indian Council for Research in International Economic Relations .” New Delhi, Febru-
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Sheng, Andrew . 2009b . “The First Network Crisis of the Twenty-first Century: A Regu-
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View of Unfettered Finance in the 1990s and 2000s. New York: Cambridge University 
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Michael Taylor . London: Central Banking Publications, pp . 125–138 .
NOTES
1 Andrew Sheng (2009c) .
2 See Haldane (2009) and Sheng (2009b)
3 Capra (1982) .
4 Koo (2009)

The Turning Point. New York: Simon and

The Weakest Link: Financial Markets, Contagion, and Networks .” Bank for International Settlements working paper,

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