Latin America & East Asia: Similarities and Differences in Financial Crises

While the Latin American Debt Crisis of the 1980s and the East Asian Financial Crisis of 1997 generally both stemmed from overborrowing from foreign lenders, the type of crisis that unfolded depended on the level of government intervention prior to the crisis and the type of crisis (fiscal or currency-based) determined the rapidity of the crisis’ development. In Latin America, heavy government intervention in the import substitution model created a heavy reliance on foreign loans, with too much capital being used for consumption. In contrast, the financial liberalization in the 1990s in East Asia created a lack of national financial supervision, causing massive inflows of foreign capital to private sources, making these sources dependent on foreign loans as well. However, the public debt of Latin America created a gradual fiscal problem in which countries no longer could service their loans, causing defaults, whereas in East Asia a few defaults caused by the real estate bubble crash led to the sudden panic of foreign investors, triggering a currency crisis and then a widespread default of Asian financial institutions. Thus, in Latin America, defaults caused destructive capital flight while in East Asia, investors speculated currency devaluation and therefore their capital flight caused further and rapid defaults. 

At the core, both crises reached breaking points as a result of foreign capital flight, implying an overreliance on foreign borrowing to stimulate the economic development. “The Asian crisis can be understood as … caused by a boom of international lending” while “the [Latin American] debt crisis had its origin … with the burst of bank lending during 1979-1981,” demonstrating that the sharp increases in foreign lending just before the crises became problematic when defaults and capital flight also happened at such rapidity (Radelet & Sachs, 1998: 2) (Swan, 1992: 19). Also, in both crises, foreign lending came primarily from aggressive international financial institutions and not governments, causing the sharp increase in loans as investors tried to turn profits from higher interest rates abroad. This became problematic as “the fast-growing Asian economies [were] heavily in debt to foreign investors, including international banks, hedge funds and other investment funds,” similar to the case in Latin America where “banks have moved aggressively to increase their foreign lending” and “[overlent] to LDCs in the 1970s and early 1980s” (Sachs & Woo, 2000: 18) (Volcker, 1980: 9) (Dymski & Pastor, 1990: 153). While for some time these loans helped to stimulate growing economies and develop various sectors, the lack of investment in productive sectors either made loans unpayable or created unmanageable asset bubbles that did not generate long term profits to service the loans and lead to financial independence. In fact, “in the 1970s, as banking expansion became predominant, the Latin American debt became so huge that it fed itself,” due to poor government intervention in the developing economy,” while “excessive unhedged foreign borrowing by the domestic private sector” in East Asia demonstrated the lack of necessary government economic involvement to prevent a financial crisis (Martínez, 1993: 67) (Fischer, 1998: 169). 

Although the aggressive capital inflow and foreign borrowing was similar in both crises, Latin American governments, in pursuit of national development through import substitution, drove the overborrowing, while in East Asia, government liberalization of financial policies and a lack of supervision allowed private sectors to borrow too much. Economic conditions as a result of import substitution development, a government intervention program, made developing economies in Latin America overly dependent on foreign loans and allowed for a diversion of investment inconsistent with long-term growth and thus Cleveland & Brittain conclude, “the rapid rise of LDC debt was due to …  overly expansive domestic policies followed by some LDCs” (1977: 739). The poor macroeconomic policies by governments allowed the debt to accumulate over time as not enough loans were invested in productive capacities in order to generate profits to pay off the debt. Although the rising oil prices as a result of OPEC policies forced governments to spend more on consumption, they still needed to take into account the long run consequences of simply feeding current consumption. Cleveland & Brittain criticize these policies, stating “a borrowing country’s entire development effort may be so poorly conceived or managed as to yield returns too small to provide the margin needed to service foreign debt obligations” because “borrowing [went] mainly to enlarge consumption in the borrowing country rather than for investment” (1977: 740, 742). Therefore, it is evident that overborrowing in Latin America was driven by governmental policies that attempted to appease citizens and help alleviate poverty in the short run, while debt continued to increase to the point of default. Further, when bank loans were “used for the import of unessential consumer goods, military expenditures, or to finance capital finance and management fiscal deficits,” the creditworthiness of these countries dropped, preventing further foreign loans and causing capital flight (Devlin & Ffrench-Davis, 1995: 123). 

In East Asia, the liberalization and deregulation of the financial sector, an attempt to further grow the economies, allowed too much capital inflow and not enough oversight to prevent asset bubbles and defaults. Sachs & Woo recount that “in the early 1990s, these countries liberalized their financial markets, with the effect that domestic banks and corporations could suddenly borrow from abroad,” which at first seemed beneficial for emerging markets, but the growing investments in non-productive sectors such as real estate made these loans vulnerable to default (2000: 22-23). Therefore, “lax prudential rules and financial oversight … led to a sharp deterioration in the quality of bank’s loan portfolios,” meaning that domestic banks began making loans to risky debtors in search of more profits, not realizing that such loans could cause them to default to the international lenders, creating a crisis (Fischer, 1998: 168). While liberalizing the market was seen as beneficial after observing the negative effects of government intervention in Latin America, the governments in East Asia liberalized too much without experience or prudent regulations to control the foreign capital and bad domestic loans, which “made the financial system vulnerable to an exogenous shock whose effect was multiplied by bank failures, creating a credit squeeze and leading to rounds of liquidations” (King, 2001: 444). Had governments enforced regulations over the types of domestic loans that could be made, the entire crisis may have been prevented since the real estate bubble would have slowed. In fact, the lack of government regulation worsened the capital flight that occurred; “the lack of clear bankruptcy laws and workout mechanisms added to the withdrawal of credit, since foreign lenders feared they would have little recourse to collect on bad loans” (Radelet & Sachs, 1998: 35). The lack of government regulation in Thailand led to an asset bubble that eventually created a currency crisis throughout East Asia, while too much government intervention in Latin America fueled consumption and slowly led to a debt crisis. 

Although both crises originated in the overborrowing of foreign loans, the Latin American Debt Crisis was a fiscal and debt crisis that grew slowly over years, while the East Asian Financial Crisis evolved into a sudden currency crisis due to investor panic, creating a ripple effect throughout the region. In Latin America, governments slowly became more indebted to foreign lenders as not enough profits were generated to service the loans; the governments simply took out more loans, “initiating the spiral of indebtedness that was eventually to explode” as the “economies … chose to go the route of borrowing more resources than they could efficiently absorb” (Martínez, 1993: 66) (Devlin & Ffrench-Davis, 1995: 124). However, eventually these governments defaulted on their loans because “their external debt [grew] faster than their ability to pay it” causing international investors to stop loaning, and creating the crisis as there was no way to continue supporting the economy at the current rates of spending (Cleveland & Brittain, 1977: 734). Therefore, the crisis was primarily fiscal as it resulted from governments neglecting to generate profits and run surpluses, instead opting to finance fiscal deficits with foreign loans. When defaults caused the foreign loans to cease, Latin American countries were forced to reduce consumption, damaging their economies. The runup to the Latin American Debt Crisis happened gradually, with countries going further into debt each year, contrary to the sudden and generally unforeseen currency crisis in East Asia. 

The crisis in East Asia reached a breaking point after the devaluation of the Thai baht, demonstrating that currency issues drove the bulk of the crisis. The massive influx of foreign loans created a real estate bubble as “too much money was poured into speculative real estate projects” and “long term, risky investments” since domestic financial institutions had a four point spread on interest rates between their foreign loans and the real estate loans they gave out (Sachs & Woo, 2000: 23) (Kim & Haque, 2002: 41). When the bubble collapsed, “the failures of finance companies helped set off the exodus [of foreign funds],” although not all domestic financial institutions had defaulted yet (Radelet & Sachs, 1998: 33). Thus, a few defaults by domestic financial institutions as a result of the real estate bubble crash caused many investors to pull their foreign capital investments, eventually leading to the baht devaluation. The devaluation of the baht made it too expensive for other domestic financial institutions to service their loans, causing widespread defaults in Thailand and a crisis throughout the region as investors feared currency devaluations in other East Asian countries as well. “The currency depreciations led to widespread bankruptcies and slow economic growth,” demonstrating that the currency devaluations fueled the crisis, rather than a gradual fiscal crisis (Kim & Haque, 2002: 41). While in Latin America the debts crippled the economies, in East Asia, the debts were only tremendous for some companies, with the sudden pulling of foreign assets creating the majority of the problems through a rapid drop in local currency value. Also, the capital flight in East Asia was driven heavily by speculation since “a swift change in expectations was the catalyst for the massive capital outflows that triggered the crisis” (Kim & Haque, 2002: 42). This sudden reversal of investor confidence sparked a currency crisis that differs from the crisis in Latin America where investors lost their confidence over time as a result of poor fiscal management. 

While these crises had major differences in their causes, their similarities demonstrate how countries should respond to crises. In both cases, capital flight worsened the economic situations of the countries more than the initial defaults. In the wake of default or currency failures, countries should insure foreign deposits so that investors do not fear losses and cause capital flight. While the insurance occurs, governments should correct the macroeconomic problems such as fiscal deficits or stimulating the recovery of an asset bubble crash. Preventing capital flight would make such corrections easier and let the economy recover since currency values would remain stable. While the Latin American Debt Crisis had less to do with currency than the crisis in East Asia, capital flight did worsen their economies since they were fueled by foreign capital. While the factors that allowed the crises to occur and the general manifestations (fiscal vs. currency) of the crises differed, both demonstrate that the over-borrowing of foreign capital and subsequent capital flight can cause significant damage to developing economies. These countries ought to balance their regulation in their economies by allowing foreign capital to fund productive sectors that generate profits, and not diverting funds to politically beneficial projects or allowing too much capital to flood the speculative, non-productive sector. 

Bibliography

Cleveland, Harold van B., and W. H. Bruce Brittain. “Are the LDCs in over Their Heads .” Foreign Affairs, vol. 55, no. 4, July 1977, pp. 732–750.

Devlin, Robert, and Ricardo Ffrench-Davis. “The Great Latin America Debt Crisis: A Decade of Asymmetric Adjustment .” Brazilian Journal of Political Economy , vol. 15, no. 3, 1995.

Dymski, Gary A., and Manuel Pastor. “Bank Lending, Misleading Signals, and the Latin American Debt Crisis.” The International Trade Journal, vol. 6, no. 2, 1991, pp. 151–191.

Fischer, Stanley. “The Asian Crisis: A View from the IMF.” Journal of International Financial Management and Accounting , vol. 9, no. 2, 1998.

Kim, Suk H., and Mahfuzul Haque. “The Asian Financial Crisis of 1997: Causes and Policy Responses.” Multinational Business Review , vol. 10, no. 1, Jan. 2002, pp. 37–44.

King, Michael R. “Who Triggered the Asian Financial Crisis.” Review of International Political Economy, vol. 8, no. 3, 2001, pp. 438–466.

Martínez, Osvaldo. “Debt and Foreign Capital: The Origin of the Crisis.” Latin American Perspectives, Translated by Luis Fierro, vol. 20, no. 1, 1993, pp. 64–82.

Radelet, Steven, and Jeffrey Sachs. “The Onset of the East Asian Financial Crisis.” NBER Working Paper Series, no. 6680, Aug. 1998.

Swan, Philip L. “Economic Reform in Latin America.” Business Economics, vol. 27, no. 2, Apr. 1992, pp. 18–23.

Volcker, Paul L. “The Recycling Problem Revisited .” Challenge, vol. 23, no. 3, 1980, pp. 3–14.

Woo, Wing Thye., and Jeffrey D. Sachs. The Asian Financial Crisis: Lessons for a Resilient Asia. MIT Press, 2000.

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