(Bloomberg Businessweek) -- By 1997, the South Koreans were pretty cocky, and for good reason. For 30 years, the East Asian country had been one of history’s economic marvels, transforming itself from a poor, war-torn wasteland into a rich industrial powerhouse. The economy wasn’t perfect: Korea’s big companies were prone to amassing too much debt and investing it in outlandish projects. But the Koreans had shrugged off such problems again and again. The future seemed secure.
It wasn’t. On July 2, 1997—almost exactly 20 years ago—authorities in Thailand relinquished their control over the national currency, the baht. With market watchers already anxious it would plunge in value, the move tipped off the Asian financial crisis, an economic storm that crashed through Thailand, Malaysia, and Indonesia, then slammed into South Korea as it spread tremors across the globe. In Korea companies tumbled into bankruptcy, and banks were gutted. Its cupboard of foreign currency stripped nearly bare, the government was forced into an embarrassing International Monetary Fund bailout. The message was clear: No economy, no matter how brilliant its performance, is impervious to a financial crisis when policymakers fail to control risk.
Twenty years later that lesson seems to have been forgotten. Even the Asian crisis feels like ancient history, overshadowed by the more traumatic Wall Street fiasco of 2008. That’s unfortunate, because the events of 1997 still offer critical insights about debt crises, how they happen, and how to prevent them. Without heeding these lessons, we leave the global economy vulnerable to more destructive financial calamities in the future.
I haven’t forgotten 1997, probably because I lived through it. I was a correspondent in Seoul, surrounded by the chaos, disorientation, and heartbreak the crisis caused. Here was a society that had worked tirelessly to climb out of poverty, only to see its hard-won gains evaporate. Housewives surrendered their gold jewelry in a gallant, but futile attempt to restore the nation’s solvency. Forlorn salarymen donned their usual dark suits and loitered in parks, too humiliated to tell their families they’d been laid off. Events were moving so fast it was difficult to pin down what had set the catastrophe in motion.
Over time, my experience helped me devise some simple rules about financial crises and why they keep happening. First, rapid increases in debt levels are always dangerous, under all circumstances. Second, those debt pileups are caused by flaws in an economy going unrecognized or unaddressed. Third, there will always be people with impressive credentials to offer smart-sounding justifications for why this debt binge isn’t dangerous like all the others. Lastly, they’ll be wrong.
Let’s apply these maxims to 1997 Korea. First, private-sector debt relative to gross domestic product had risen precipitously. By mid-1997, it had reached 149 percent, a 52-percentage-point jump in only a decade. (The surges in Thailand and Malaysia were even bigger, 99 and 62 percentage points, respectively, while in Indonesia, the ratio nearly doubled.) Korea’s debt was amassed, in part, because of a fault line in the country’s economic system: Cozy ties between bureaucrats, bankers, and businessmen funneled large sums to favored corporations to pursue white-elephant projects instead of profits. Officials, meanwhile, discounted the risks. The economy had always benefited from this state-guided form of capitalism, so why worry? It’s true the crisis was sparked by an external shock—contagion ricocheting from Thailand panicked investors and bankers—but by ignoring the economy’s fragilities, Seoul had left itself vulnerable to just such an unexpected blow.
History tells us this pattern repeats itself with sickening regularity. In 2015 research firm Capital Economics Ltd. studied emerging-market meltdowns since 1990 and discovered that every country that had experienced a rise in private debt relative to gross domestic product of more than 30 percentage points over the course of a decade ended up in some sort of banking crisis.
If we’d digested the lessons of the Asian crisis, we might have avoided the 2008 disaster. The ratio of private-sector debt to GDP in the U.S. rose by 44 percentage points over the decade through mid-2008. Too much of that debt was tied up in high-risk mortgages made in a bloated housing sector. Any student of ’97 would have lost sleep. But regulators and bank chiefs didn’t blink. By slicing up the stinky subprime debt and spreading it around the financial sector, you could make it smell less bad. That notion sounds patently absurd today, but a lot of smart people swallowed it whole. The entire banking sector was unprepared for its “Lehman moment.”
The latest offender is China, which is experiencing a debt extravaganza every bit as spectacular as the one that unfolded ahead of 1997 in Korea and its partners-in-crisis. At the end of 2007 private debt to GDP stood at 118 percent; by the end of 2016 it had mushroomed to 211 percent—a 93-percentage-point hike in less than 10 years. The causes in China are reminiscent of Korea, too. Government meddling directs credit to connected companies, which make investment decisions based on perceived national priorities. That creates too many factories, which then require more loans to keep running.
As in pre-crisis Korea, there’s no shortage of dismissive explanations for why China’s debt bomb won’t explode like all the others: The debt is mainly domestic, making the country less susceptible to the outside shocks that brought down Korea. A large part of the debt is in loans made by state banks to state enterprises, which means the government can control it. My favorite excuse is that China has proven its critics wrong for three decades and will continue to defy the naysayers.
Perhaps China can dodge a 1997-style meltdown. But the recipe is too similar to the one that cooked Korea to be reassuring. The Asian crisis clearly shows that an economy’s past successes can’t inoculate it from future disasters. Allowing such a runup of debt, Beijing is leaving the Chinese economy susceptible to any unanticipated event that undercuts confidence in the financial system. Who would ever have guessed the depreciation of the Thai baht could spark such global turmoil?
Recent events have offered a glimpse into just how fragile China’s financial system is. The politically connected chairman of Anbang Insurance Group, one of the nation’s most acquisitive firms, suddenly left management. Chinese media reports claimed he was secreted away by authorities, sending a shiver through financial markets and highlighting the lack of transparency and high-risk business dealings of many top mainland firms. Then shares and notes of units of Dalian Wanda Group, another highflier, plunged based on mere rumors that banks were dumping its bonds, which the company denied.
To be fair to Chinese officials, they’re aware of the danger, and in recent months have attempted to curb credit growth. But it may be too late. More and more companies are so highly leveraged they require fresh credit simply to pay off old loans. Beijing has permitted its debt bomb to tick for so long, it’s become extremely difficult to defuse.
Here’s where things get really depressing. We know a lot about financial crises, thanks to Korea’s experience in 1997 and other cases, but we keep making the same mistakes anyway. All too often, policymakers choose political expediency, greed, and inertia instead of making the fundamental reforms required. The Koreans embarked on a program to strengthen bank management, clean up corporate governance, and encourage entrepreneurship only after the crisis had done its worst. In China an authoritarian regime has sacrificed financial rationality to prop up the unsustainable growth rates that give the Communist Party its legitimacy. What China really requires is the state’s withdrawal from the economy, to allow the market to allocate finance in more rational ways that would improve sagging productivity gains.
There are few signs of that happening, which means China will remain a cloud of risk hovering over the global economy. The Asian crisis provides a strong hint of the costs of such mismanagement. Korean taxpayers paid a hefty bill for fixing the financial sector—equivalent to 31 percent of the country’s GDP; Thailand and Indonesia spent relatively much, much more. That implies China could be facing a $3.5 trillion tab—possibly even bigger. I hope we don’t experience a new Asian financial crisis. I’d feel more comfortable about our prospects if we had heeded the last one.
To contact the author of this story: Michael Schuman in at contactschuman@gmail.com.
To contact the editor responsible for this story: Howard Chua-Eoan at hchuaeoan@bloomberg.net.
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