FAIT Committee Report

A.        East and Southeast Asia

In East Asia, financial markets have been the primary target for reforms, triggered by the aftermath of the Asian Financial Crisis in late 1997. For decades, the region had enjoyed unprecedented economic growth, development and poverty alleviation. However, this strong period of sustained economic growth was interrupted dramatically in 1997 in Thailand with a series of speculative attacks against the Thai currency, the baht. The crisis in Thailand became a contagion almost instantly as investors rapidly lost confidence in the entire region, pulling out of equity markets in neighbouring countries such as Malaysia, Indonesia and the Philippines. Soon after, the effects spread to South Korea, Hong Kong, Taiwan and Singapore. In the end, virtually all East Asian countries were touched by the contagion, with the notable exception of China.

The Asian Crisis was the result of a combination of macroeconomic factors. Prior to the crisis, most countries in the region operated fixed exchange rates tied to the value of the U.S. dollar. As investment in the region increased, a number of countries began to run considerable current account deficits, placing downward pressure on domestic currency values. Instead of devaluing domestic currencies, countries responded by raising their interest rates and selling foreign exchange reserves in order to defend the value of their fixed exchange rates. This made the region an even greater magnet for foreign investment and resulted in an abundant supply of foreign currency in East Asia.

Because foreign currency was plentiful, it became common to borrow money in foreign currency denominations. Since local governments had promised to defend the fixed exchange rate in money markets, this was seen as no less risky than borrowing money in the domestic currency.

At the same time, the financial institutions administering these loans suffered from inadequate supervision and a poor performance in assessing and managing financial risk. This led to an improper allocation of financial resources; loans were too liberally extended and frequently channelled into unproductive investments, nepotistic ventures, and unwise capital projects. Governments were also guilty of directing loans to un-creditworthy firms and industries. In some planned economies such as South Korea, and to some extent Japan, banks were seen as mere policy arms of the government.

This had two results. First, speculative investment became common and the value of Asian real estate and other asset markets were driven to artificially high levels. Second, the number of non-performing loans soared. These loans for the most part represented short-term debt held in foreign currency denominations — usually U.S. dollars.

This combination of factors began to signal cause for concern in East Asia. Expanding current account deficits required governments to raise interest rates and sell off foreign reserves in order to maintain fixed exchange rates. Trying to maintain exchange rates at artificially high levels hurt the competitiveness of Asian exports abroad and had a significant negative impact on local equity markets, even as prices for real estate and other assets soared.

Foreign and domestic investors began to worry that East Asian countries would not be able to sustain their fixed exchange rates in such an economic environment. At the same time, the implications of allowing exchange rates to float became clear. Given the number of loans denominated in foreign currencies allowing exchange rates to fall would dramatically increase the cost of these loans.

This speculation triggered the Asian Crisis which began, as mentioned above, in Thailand with a wide-scale sell-off of the local currency, the baht. The Thai government initially defended the currency by further raising interest rates and selling off foreign reserves, but once it was clear that the government would not be able to support the baht, the exchange rate was de-pegged and the baht was allowed to float. Its value plummeted immediately, and the panic quickly spread to neighbouring countries.

The combination of this sudden outflow of foreign capital and higher interest rates caused the speculative bubbles in real estate and other asset markets to pop, triggering massive deflation in the value of assets in the region. At the same time, the plunging exchange rates dramatically raised the costs of holding debts in foreign-currency denominations. These factors caused declines in spending, production, and employment in the region, as well as a sharp increase in the number of bankruptcies.

In addition, the sudden collapse of asset values and the flight of capital out of the region exposed the dangerous lending practices that had been allowed to persist in the Asian financial sector. As the number of bad loans became apparent, financial institutions were unable to recoup their losses and many became insolvent.

The turmoil created by the Asian Crisis had a dramatic effect on the regional economy. In 1998, economic activity fell by 9% in Southeast Asia and by 3% in the NIEs. The three hardest-hit countries were Thailand, South Korea and Indonesia. Although many countries have since recovered from the crisis, weakness persists in some areas, most notably Japan where the financial crisis was only one of a number of economic challenges endured over the 1990s.

As mentioned above, China was one of the few countries essentially unaffected by the financial crisis. China’s currency is fixed in value by the government and is not traded freely on global currency markets. As such, it was immune from attacks from currency speculators. As well, unlike Thailand and South Korea, China had a current account surplus at the time of the crisis. In addition, foreigners are heavily restricted in the types of shares they can trade on China’s stock exchanges.

As Brian Hunter testified, the Asian Crisis revealed the need for significant institutional reforms in East Asia. He pointed out that the region was quick to react, initiating a series of economic and financial sector reforms aimed at improving transparency and accountability in the financial sector, decreasing the number of non-performing loans and improving the overarching legal and regulatory environments. Reforms are ongoing, but most countries have surpassed expectations in the progress they have made.

As a result of the crisis, a number of countries are implementing measures to ensure that such an event does not take place again. The Subcommittee heard that Thailand, for example, has accumulated vast quantities of foreign reserves to protect the baht from any future dramatic deviation outside its target band.

Robert Bélanger informed the Subcommittee that Thailand felt betrayed by the international community, believing that timelier assistance would have reduced the severity of the crisis in that country. Mr. Bélanger also stated that Canada was one of the few countries to step in to defend Thailand, providing an unconditional $500 million loan during the crisis. The Thai government is repaying the loan on schedule.

B.        China

Economic reformation in China has been a gradual process, dating back to the late 1970s. The death of Chairman Mao in 1976 and the subsequent arrest of the remaining members of the “gang of four” brought an end to China’s Cultural Revolution (1966-1976) and opened the door for more moderate party members to assume control. In December 1978, at the third plenum of the 11th Party Congress, these moderates approved an ambitious series of agricultural and economic reforms. The economic reforms, known as the Open-Door Policy, were aimed at reforming the national economy and lifting the restrictions on foreign commercial relations.¹⁹ The Open-Door Policy was made up of four components: the creation of special investment zones; the attraction and efficient investment of foreign capital; increasing foreign trade; and the import of modern technology and management techniques.²⁰ Reforms were phased in through the remainder of the 1970s and into the 1980s.

In subsequent years, economic reforms in China continued, at least one of the goals of which was to formally join the multilateral trading community. In 1986 China applied to join the General Agreement on Tariffs and Trade (GATT), the predecessor of the WTO. Discussions were set back by the Tiananmen Square massacre in 1989 and also by the creation of the WTO in 1994, which widened the scope of GATT rules, requiring China to undertake even more economic reforms in areas such as new or increased market access commitments and intellectual property rights.

In 1996, the European Union proposed that upon accession to the WTO, China be allowed transition periods to implement certain WTO obligations. This proposal helped invigorate WTO negotiations and economic reforms in China, that had been lagging. The following year, China began to restructure its state enterprise sector, allowing for a greater role to be played by markets. With new progress made on negotiations, China concluded several bilateral market access agreements, including with Canada in 1999. These agreements paved the way for China’s eventual accession to the WTO in December 2001.

Chinese economic reforms will continue into the immediate future as well. This is due in large part to the transition period for phasing in certain WTO commitments. In particular, China is reforming its financial sector to allow greater access to Chinese financial markets by foreigners. This also involves further reforms to Chinese monetary policy. For example, the domestic currency, the remnimbi, is not yet fully convertible on international markets. Many countries are optimistic that China’s participation in the WTO will serve as a catalyst for even further market reforms.

C.        India

India is also engaged in a series of economic reforms, largely as part of its effort to increase economic growth through trade and trade liberalization. John Wiebe informed the Subcommittee that the Indian government was in the process of selling a number of state-owned enterprises. In addition, import duties on most products are falling in accordance with its tariff reduction schedule which extends through 2005. Tariffs on raw materials and industrial goods in that country have fallen from an average of 300% in the early 1990s to about 25% today. India has plans to continue to lower its tariff rates to bring them in line with those of the ASEAN countries.

However, this plan is complicated by the fact that government revenue needs in India are slowing the pace of tariff reduction. India has a population of over 1 billion, but only an estimated 18 million pay income taxes. As a result, import duties are a significant source of revenues in India. With a large and chronic fiscal deficit, the Indian government is looking to implement a Value-Added Tax (VAT) on consumption that would help widen the tax base, generate more revenue and provide the tax room necessary to afford additional tariff reductions.

In addition to these broad national reforms, a number of India’s southern states have enacted economic and regulatory reforms aimed at attracting foreign investment and economic development. These policies have largely been successful and as a result, much of southern India has seen remarkable growth in recent years. By contrast, most of northern India is stagnating as political instability along the Pakistani border and less liberal policies are dampening development.

D.        Japan

Japan is also engaged in a series of economic reforms as the country attempts to break out of its prolonged period of economic stagnation. Japan’s poor economic performance since the early 1990s is rooted in its economic policy in the 1980s. At that time, restrictive trade policy aimed at promoting exports and minimizing imports proved to be very effective, resulting in a large and growing trade surplus, that in turn, placed upward pressure on the yen. A rising yen not only threatened the competitiveness of Japan’s exports, but spelled slower economic growth as well. To stimulate growth and place downward pressure on the yen, the Japanese government lowered interest rates and increased government spending. While this policy helped restore economic growth in Japan in the mid-late 1980s, low interest rates and a ready supply of government money also created tremendous inflation in Japanese asset markets. The rise in stock and land values became self-perpetuating as speculative investment took over. When the asset-price bubble finally burst in the early 1990s, it triggered a prolonged period of price deflation that eroded consumer spending and left producers with large surpluses in production capacity brought about by excessive capital investments in the 1980s.

The decline in asset values left Japanese banks saddled with volumes of non-performing loans, causing devastation in the financial sector and making banks far more reticent to provide loans in subsequent years. As the financial sector continued to struggle with non-performing loans and mounting debt levels in
a deflationary environment, Japan was hit by the Asian Crisis in 1997, exacerbating the difficulties of financial institutions and resulting in high-profile bankruptcies in the sector.

In an effort to stimulate economic growth, the Japanese government implemented a number of fiscal stimulus packages throughout the 1990s. However, these spending projects have been unsuccessful at jump-starting the Japanese economy and have only resulted in a burgeoning national debt. In 1991, net debt in Japan was only 6% of national GDP — the lowest level in the G-7. Ten years later, net debt had mushroomed to nearly 59% of GDP, making Japan the second most indebted country in the G-7. Indeed, John Wiebe informed the Subcommittee that there is very little the Japanese government can do to further stimulate the economy. Interest rates are near zero, and the high debt level limits the ability of the Japanese government to make future interventions in the economy.

However, Mr. Wiebe was quick to point out that the perception of Japan’s economic weakness is much more severe than is actually the case. Indeed, while travelling through Japan, the Subcommittee consistently received the same message from Japanese business leaders and Canadian companies operating in Japan.

In recounting the recent performance of the Japanese economy, an economist in Tokyo likened the challenges facing Japan to a “rich man’s disease.” Japan is still among the wealthiest countries in the world and its current economic woes are the result of its earlier, overzealous growth to prosperity. He stated that it would take time, but Japan would surely recover and the domestic economy would once again resume growth.

In the meantime, Japan is engaged in a number of economic and political reforms aimed at restructuring the economy, attracting foreign investment and accelerating the recovery process. The Subcommittee heard that the Japanese government has divided the country into a series of economic zones to act as pilot projects for the implementation of various reforms and to speed their acceptance.

Among the specific areas targeted for reform are corporate restructuring, particularly in the financial sector. Many Japanese banks are still saddled with high debt and large numbers of non-performing loans, exacerbated by a deflationary environment. Other goals include regulatory, tax and political reforms. There have also been some attempts to change Japan’s hugely inefficient distribution system to try to make it easier for countries to export to Japan and for foreign companies to establish Japanese operations. Indeed, in the Subcommittee’s meetings with Canadian companies operating in Japan, the inefficient and complex distribution system was cited as one of the most significant obstacles to penetrating the Japanese market.