nzref-vol-4
TRANSCRIPT
Volume 4, 2015
In this issue:
Trang Dang: Auckland House Prices
Eleanor McKitterick: The Economics of Disaster Preparedness: Priority 4 of the Sendai Framework
Michael Sutton: The challenges Auckland’s housing market presents to New Zealand’s banking system
Terence Tong: The causes of the 1997 Asian Financial Crisis and how Taiwan was immune to it
Managing Editor
Ilkin Huseynov
Editorial Board
Hannah Altman, Thakshila Gunaratna, Chung Thanh Phan,
Faculty Advisors
Morris Altman, Chia-Ying Chang
The Editorial Board of the New Zealand Review of Economics and Finance would like to
express their sincerest thanks to the School of Economics and Finance and Victoria Business
School for financial and administrative support in publishing this edition of the journal.
Contribution
We are interested in publishing high quality economics or finance papers written by students.
Submissions should be sent to [email protected], with ‘NZREF Submission’ in the title line. Documents
should be in word format, and preferably between 2500 and 4000 words.
The journal has ISSN: 2324-478X and is distributed widely in print to universities, private corporations
and government agencies. An online version and more information about the journal are available at:
http://ojs.victoria.ac.nz/nzref
http://www.victoria.ac.nz/sef/research/student-journal
Welcome to the fourth volume of New Zealand Review of Economics and Finance 2015. The
New Zealand Review of Economics and Finance is a publication run by undergraduate and
postgraduate students at Victoria University of Wellington. We aim to produce high quality
research work by the students, with the goal of encouraging scholarship and interest in
economics and finance.
In this issue we feature a wide range of work. Trang Dang examines the main causes of
Auckland housing bubble, and the impact of bubble burst on households, banks and financial
stability. Finally, he compares Auckland housing situation with the Irish housing crash that
happened during the global recession.
Eleanor McKitterick studies the Economics of Disaster Preparedness, particularly the fourth
priority of the Sendai Framework and explains how the Early Warning Systems may be the
most effective tool for achieving this priority.
Michael Sutton examines the risks to New Zealand banking system associated with the
Auckland housing market. The essay further analyses whether macro-prudential policies and
banking management are currently working, and if they would be effective in a crash.
Terence Tong investigates the causes of the Asian Financial Crisis and then describes how
Taiwan - a small open economy managed to escape from this crisis and was able to cope more
successfully than most of other economies in East Asia.
CONTENTS
1. Auckland House Prices,
Trang Dang ............................................................................................................ 1
2. The Economics of Disaster Preparedness: Priority 4 of the Sendai Framework,
Eleanor McKitterick ............................................................................................... 8
3. The challenges Auckland’s housing market presents to New Zealand’s banking system,
Michael Sutton ...................................................................................................... 16
4. The causes of the 1997 Asian Financial Crisis and how Taiwan was immune to it,
Terence Tong.......................................................................................................... 28
1
Trang DANG 1
Abstract:
Rising house prices in Auckland has been a concern for New Zealanders for financial stability.
High house price-to-income and debt-to-income ratio have negative impacts on low income
earners. However, while the picture of high level of house prices seems bad, it is worse when
the prices drop. Since houses are usually used as collateral for acquiring loan and mortgage
contracts, housing price burst means banks and financial sectors that provide loans suffer,
affecting the whole system. This situation had happened in many countries that faced house
price bubbles. The consequences are lower Gross National Product and economic tragedy.
1 Email address: [email protected]
Auckland House Prices
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Introduction
Housing bubble is a phenomenon in the late twenty and early twenty first century. A house
price bubble happens when price of houses are significantly higher than their intrinsic value,
(Brunell, 2015). The bubbles usually occur during the boom, then it burst when recession hits.
Many countries in the world has experienced house price crash, especially during the recession
in 2007 – 2008, including big economies such as the Unites States, Australia, China, India, etc.
Auckland is believed to experience housing bubble recently, creating a few worries on the
future of the economy and financial stability. This essay will first summarise the main causes
of Auckland housing bubble, including an increase in the number of net immigrants, a decrease
in interest rate, and the expansion of investors’ demands in Auckland. Then, we will look at
the reasons that make the Reserve Bank consider housing bubble in Auckland as a threat to the
financial stability. After that, this paper will demonstrate the issues that arise when house prices
fall, especially how it will affect households, banks and financial stability. Finally, we will
compare and contrast Auckland situation with the Irish housing problem happened during the
global recession to see if the crisis is likely to happen to New Zealanders.
Auckland’s Housing Bubble – the Causes
Auckland house price has been rising sharply, creating a house price bubble recently.
According to Spencer (2015) demand is believed to be the main factor that drove up housing
price. There are factors that affect demand for houses in Auckland. Firstly, the number of
immigrants and returning Kiwis in Auckland has been escalated, leading to strong demand for
houses which caused a shortage in supply. Around 50,000 long-term migrants and returning
Kiwis settled in Auckland last year, estimated to account for nearly 10,000 house sales
(Spencer, 2015). Secondly, the falling interest rates, including mortgage rates have stimulated
demand for houses. Falling interest rates imply the discount rate used to calculate the present
value of houses based on their future payment is now lower. The cost of borrowing is cheaper
than before. Therefore, income earners have incentive to expand the level of mortgage they
acquired, and demand more houses. Thirdly, the increase in the number of investor demands
for houses to normal household demands is also put pressure on house price. In June 2015, 41
percent of Auckland’s house sales fell into investors assets (Core Logic data as cited by
Spencer, 2015). While household demands only drive up price by creating a supply shortage,
investor demands also do so, plus setting the house at a higher price so that they can generate
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profit from their investments. Additionally, there are several other reasons that lead to a high
house price in Auckland today, such as a fall in New Zealand currency that boosts overseas’
purchases; or certain public policies that allow foreigners to invest in real estate easily; or the
increase in building costs. However, demographics, interest rates and investors demands are
considered to be the main causes.
Problems Associated with the Bubble
There are several problems associated with high house prices. From economists points of view,
high house prices that was caused by high mortgage credit in Auckland is a problem because
it means households are living in high private debt. On average, household debt is going at
around 155 percent of household income, (Spencer, 2015). When the debt-to-income ratio is
high, income earners do not have strong financial statements and may suffer during unexpected
events. Moreover, a number of investors were pulled into the housing industry, creating an
investment imbalance between housing industry and other industries within New Zealand. Less
business investments might become a constraint for the growth of the economy. While house
prices are high and the market looks attractive, it is only considered as a bubble, which does
not last forever. Therefore, there is a risk facing all housing investors when the price suddenly
drop, or in other words, when the bubble burst. Besides that, house price-to-income ratio has
increased from 6 to 9 in the past few years, and is approaching 10 lately, (Spencer, 2015). This
means that Auckland house price is at the top ten unaffordable places in the world, (Walters,
2015). Low-income earners are those that are badly affected as they cannot afford a house for
their family. Some people go ahead to obtain a mortgage, putting themselves into debt as
interest rate is low. Consider the fact that low-income earners do not have good prediction
about the housing market, and clearly they do not know when is (or is not) a good time to buy
houses, and when the price will fall. And when the bubble bursts, lower income households
suffer even more. This then raises the topic of inequality in New Zealand.
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The Bubble Burst
4.1 House Prices and Households
The rise in Auckland house price is a threat to New Zealand’s financial stability because people
do not know when the bubble will burst. Falling house price generally has negative effects on
the economy and financial stability. It impacts households under negative equity effect while
impacts banks and other financial sectors through mortgages and investments. With households
or consumers, a decline in house price means that their current properties – their houses – will
experience a drop in value, called negative equity. Negative equity happens “when the market
value of a house is below the outstanding mortgage secured on it”, (Hellebrandt et al. 2009, p.
110). According to Hellebrandt et al. (2009), there are two reasons to say that negative equity
is bad for consumers. Firstly, since houses can be used as collateral to obtain secured loan and
mortgage, a drop in house price is equivalent to a reduction in collateral, adding to the
borrowing cost and making it less favourable to have a loan. As a result, households’ aggregate
borrowing and spending are reduced. Secondly, lowering the value of housing equity reduce
the value of the resources that households can draw on during unexpected events. In real term,
people have lower in their redundancy, and their consumable income is restricted as part of
their income goes into saving, in case something unexpected happens. Besides, falling house
price also has a considerable negative impact on consumer confidence and expectation, which
reduce the purchasing power. In overall, the result of house price falling is lowering spending
and increasing saving, which then slow down economics activities and build up a threat of a
recession.
4.2 House Prices and Banks
House price reduction also has a negative relationship with banks and financial sectors’
performance. It leads to an increase in the number of mortgage defaults and other loan defaults,
creates losses at banks and may cause financial instability, (Federal Reserve Bank of San
Francisco, 2009). In an environment where house prices are high, homeowner is better off
when he sells the house. The reason is that the gain from selling the house exist the value of
the mortgage. Mortgage lenders also benefit from high house price situation. Because of an
income distribution not every person owns a house or be able to make mortgage payment.
There are always new mortgage contracts as people see the potential market, where rents are
high in association with the house price, rental income can cover interest payments on
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mortgage. People gain from having mortgages that come together with leases. Banks gain from
interest income generated from lenders. On the other hand, there are also defaults. However,
as house price is high, the value of collateral associated with the mortgage worth more. Thus,
in the situation of any default, banks do not lose but gain from selling or using the collateral
asset. In contrast, when house price become lower, at the current market price, the mortgage
worth more than the house. The total amount of money the owner can get from selling the
house cannot cover the mortgage price. Therefore, there is no point continuing the mortgage
though defaulting involves penalty costs. Banks are worse off because they have to write down
defaulted mortgages and moreover, have to write down the value of the collateral as well. In
addition, as housing wealth links with household wealth, banks might face other loan defaults
as well when people spending is not yet adjusted to the drop in their properties’ value. Under
the system where banks are lenders of each other, too many defaults will strongly impact banks
and other banks, and thus, leading to a financial instability situation.
Lessons from Irish Housing Crisis
Many economics experts believe that Auckland house prices bubble is in the danger to repeat
Irish housing crisis. According Lyons (2015), bubbles can be classified into statistical and
economic bubbles. Statistical bubbles occur when prices increase unsustainably over a period
of time while economic bubbles happen when prices increase due to excess capital, (Lyons,
2015). In Ireland, economic bubbles appear due to many factors. Before the recession in 2007,
Ireland has been achieving a level of output above the natural level, partly thanks to
multinational corporation investments. The employment rate was high leading to higher wages
up by 30%. High income, together with a change in demography in which people prefer living
in smaller family, low interest rate and easy mortgage conditions are contributing factors that
made demands for houses to surge, (Kelly, 2009). Similar pattern is happening in Auckland,
causing economic bubbles for houses and other assets. However, the real crisis only happens
when the bubble bursts. Media plays a huge role in building expectations that contribute to the
burst. As long as house price reaches the peak (even though it is hard to tell at which level does
the peak lies), New Zealanders will face a period of falling house prices, leading to financial
instability and crisis. Ireland's house prices started rising by the end of the nineteenth century,
reaching its peak in 2007, then started falling until the second quarter of 2010, accounted for
35 percent drop in price, (Gibson, 2015). The consequences of the collapse of the bubble are
dramatic. Ireland’s Gross National Product fell over 25%, and unemployment was above 15%.
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Too many constructions during the bubble created an excess supply, lowering house price and
put house owners and investors into a difficult situation. People defaulted on bank loans, which
led to the post 2008 Irish banking crisis. As a result, the government had to bail out banks, and
the economic situation got worse.
Conclusion
House price bubble in Auckland was mainly driven by high demand for houses. Similar to Irish
people in the 1990s, New Zealanders were facing low mortgage cost and favorable conditions,
which attract them to buy a house. When the bubble burst, people will change their spending
and saving behaviors. They will save more and spend less since the assets that they own – their
houses – have dropped in value. This adjustment will strike the economy by lowering total
output and put the country into a threat of facing a recession. Banking sectors are also worse
off from the drop in house prices. As people lose in terms of their assets, banks will have to
write off bad debts and moreover, write down the collateral value of the associated assets. Once
the size of the problem gets large enough, the financial health will be affected, commonly
known as financial instability. In conclusion, either a housing bubble or burst would undermine
the financial stability. Having a bubble is bad, but experiencing a burst is even worse.
Reference
1. Burnell, S. (2015). Week 9 ECON 352 Bubbles. Unpublished lecture slides, Victoria
University of Wellington, Economics and Finance Department, New Zealand.
2. Gibson, A (2015, January 23). Housing warning: It's an Ireland repeat. New Zealand
Herald. Available at:
http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=11390463
3. Hellebrandt, T., Kawar, S., & Waldron, M. (2009). The Economics and Estimation of
Negative Equity. Bank of England Quarterly Bulletin, 49(2), p110-21. Available at:
http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb090203.pdf
4. Kelly, M. (2009). The Irish Property Bubble: Causes and Consequences. The Irish
Economy. Available at: http://www.irisheconomy.ie/Crisis/KellyCrisis.pdf
5. Krainer. J, (2009). House Prices and Bank Loan Performance. Federal Reserve Bank of
San Francisco Economic Letter, Number 2009-06. Available at :
http://www.frbsf.org/economic-research/files/el2009-06.pdf
NZREF Vol.4, 2015
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6. Lyons, R. (2015). When does a housing bubble start?. The Irish Economy-2015-July 2.
Available at: http://www.irisheconomy.ie/index.php/2015/07/02/when-does-a-housing-
bubble-start/
7. Spencer, G. (2015). Investors adding to Auckland housing market risk. Reserve Bank of
New Zealand. Available at:
http://www.rbnz.govt.nz/research_and_publications/speeches/2015/investors-adding-to-
auckland-housing-market-risk.html
8. Walters, L. (2015, January 19). Auckland in world top ten for housing unaffordability:
Report.Stuff.co.nz. Available at: http://www.stuff.co.nz/business/65176275/Auckland-in-
world-top-ten-for-housing-unaffordability-report.
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Eleanor MCKITTERICK 2
Abstract:
The Sendai Framework for Disaster Risk Reduction 2015-2020 has vital importance to the
United Nations as a guideline for reducing vulnerabilities and economic losses of nations
related to potentially devastating natural disasters. The fourth priority of the Framework
focuses on preparedness, response and ‘Building Back Better’, including the key roles of
women and the disabled in these processes. Early Warning Systems may be the most effective
tool for achieving this priority, however major political and economic barriers exist and the
ability to invest in such a system differs from country to country.
2 Email address: [email protected]
The Economics of Disaster Preparedness:
Priority 4 of the Sendai Framework
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Introduction
The Sendai Framework for Action for Disaster Risk Reduction was signed in March this year
at the third UN World Conference with the express purpose of providing guidance for nations
in reducing disaster risk during the next 15 years. It builds on the previous Hyogo Framework,
while narrowing Hyogo’s five priorities for action down to four, providing a more specific
frame of reference (Kirbyshire, 2015). This report focuses on Priority 4 of the SRDRR and
more specifically on the economic factors enabling and hindering the implementation of Early
Warning Systems.
The Fourth Priority: Inclusion of Women and the Disabled
The focus of the fourth priority of the Sendai Framework is “enhancing disaster preparedness
for effective response and to “Build Back Better” in recovery, rehabilitation and
reconstruction” (United Nations, 2015, p.14). It stresses the importance of preparing for the
aftermath of a disaster before it happens, to ensure the resilience of nations and communities
to the event. The Framework calls particular attention to equality and universally accessible
response for women and people with disabilities, ensuring the knowledge and diverse
experiences of key groups of the population are not overlooked as they are important resources
in disaster preparation and vital factors of an effective recovery (United Nations, 2015). During
the conference in March, it was pointed out that women have not been recognised in the past
for the significant roles they play after a disaster, despite their tasks being of equal importance
to the men’s. For example, after the 2010 Great East Japan Earthquake, men were given a daily
allowance for clearing rubble in evacuation sites while the women preparing food at these sites
received no compensation for their work (Bhatt, 2015). This persistent oversight of the value
of women in the earthquake recovery was a direct result of the underrepresentation of women
on the Sendai City Disaster Prevention Council. Disabled people were also identified as being
underrepresented in the previous Framework for Action, despite the fact that around 15% of
the world’s population is classified as disabled and also faces higher risks during and after a
disaster due to restriction of access (McElroy, 2015). However, the creation of separate plans
for dealing with the specific needs of the disabled and women in disaster risk reduction has
been found to be futile and ineffective in the past (McElroy, 2015). The integration of the
relevant needs of women and disabled people, as well as their skills, knowledge and experience,
into current policy development, risk assessments, and disaster management plans would be
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more cost-effective than creating separate, ultimately ineffective plans (McElroy, 2015).
Inclusion would lead to an increase in capacity due to an increase in human capital. Social
capital, or the relationship networks formed among people living and working together, may
also increase as communities become more egalitarian and inclusive, resulting in greater
resilience to disasters (Aldrich, 2013). However, empowering these two groups to publicly lead
and actively participate in improving economic recovery, rehabilitation and reconstruction in
their country and community requires coordination between individuals, community
organisations and the government (McElroy, 2015). This partnership may be difficult to form
due to factors like culture and discrimination, limiting the freedom of these two groups to
function within their societies at both national and local levels. This aspect of Priority 4 shines
a light on the economic illogic of excluding the knowledge and wisdom of women and the
disabled from the process of improving economic recovery after a disaster.
Early Warning Systems: Economic Factors Hindering Implementation
The implementation of Early Warning Systems (EWS) will be an important way in which
disaster preparedness for effective response can be achieved, according to Priority 4 of the
Sendai Framework. More specifically, EWS that are people-centred, multi-hazard and
multisectoral, so that they include all the possible hazards faced by a nation into one centralised
system for warning. An economic factor hindering the investment in EWS is that high-impact
events often occur with low-frequency, meaning government officials do not place high priority
on them (Wood, 2014). It is for this same reason that voters give low priority to preparing for
such events, as they are generally more concerned with the events that affect them on a daily
basis. These low political incentives are a particular hindrance in developing countries, like
Nepal, where both politicians and communities prioritise events that are highly likely to affect
them in the near future. For example, individuals who live day-to-day would prefer that their
communities and government commit to investing in infrastructure that will improve provision
of lifelines, like water and electricity. The perception may be that benefits are more likely to
outweigh costs with this kind of expenditure than when spending money on EWS for an event
which may never happen. As a result, there would be huge barriers to creating the commitment
at national and local levels required for implementing an EWS as it would be difficult to
develop a people-centred system if the people are not interested. This would also be a hindrance
in countries with a higher standard of living, although possibly to a lesser extent. Priority may
still be placed on investments that would affect them in the near future. These investments may
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be classified more as luxuries than necessities, for example neighbourhood beautification or a
new community pool. However, these projects and policies may still be considered more
important to implement than a system to warn of an infrequently occurring event. As well as
low political incentives, the political cycle within a country would also hinder the
implementation of EWS, as the new administration may be less willing to commit (Wood,
2014). This would be a particularly high barrier in countries with short cycles, like New
Zealand, where the government changes every 3 years.
Another economic factor hindering the implementation of EWS is access to the long term
funding required to ensure that the system survives and flourishes. The Sendai Framework
specifies that EWS should be invested in, developed, maintained and strengthened, indicating
that EWS is a long term commitment (UN News Centre, 2015). Finding the funding for the
Seismic Alert System of Mexico was a challenge to its implementation, as they needed a
commitment for a period of 10-20 years (Wood, 2014). Without this level of capital, any multi-
hazard, multisectoral forecasting and warning system would likely fail. Maintaining such a
system requires coordination of many stakeholders and entities that are responsible for
monitoring different data and indicators for specific hazards 24 hours a day (The United
Nations Office for Disaster Risk Reduction, 2006). The system must also be regularly and
frequently reviewed and improved upon in order to avoid redundancy or failure, which would
endanger the lives of those accustomed to relying on the early warning system. It would be
inefficient to invest in EWS in the first place if there were to be any doubt about its longevity.
Again, the costs would outweigh the benefits. Another aspect of this hindrance is corruption of
a country’s political system. The higher the level of corruption, the less likely it is for any given
funding to be allocated efficiently and appropriately to ensure the continuation of an EWS in
the long term.
In a multi-hazard system, many different entities need to be coordinated for one public interface
with one agency facilitating this horizontal integration, which would be an economic factor
hindering the implementation of such a system (Carby, 2006). The Shanghai Multi-Hazard
EWS is the world’s first multi-hazard system, from which warnings are disseminated for
hazards including tropical cyclones, extreme temperatures and disease (UN News Centre,
2015). Warning for these particular events would require information from the Shanghai
Meteorological Bureau, the Water Affairs Bureau and the Health Bureau. This showcases the
potentially high barriers to implementing this system, as it could prove difficult to
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comprehensively coordinate the necessary expert entities under one system in a timely manner.
This would result in diseconomies of scale, due to increased costs resulting from inefficiencies
(The United Nations Office for Disaster Risk Reduction, 2006). However, the opposite effect
would result if all stakeholders were organised into a high-functioning partnership.
The barriers to broadcasting effective warnings caused by inadequate access to resources are a
significant economic factor hindering the implementation of Early Warning Systems as laid
out under Priority 4. The dissemination of timely warnings which carry the authority of the
government is a vital component of an effective EWS (World Meteorological Organisation,
2015). These messages need to reach three groups of people: the authorities, EWS stakeholders
and the at-risk population (World Meteorological Organisation, 2015). In a first world country
where technology and social media are easily accessible, this would not be a difficult task.
However, many developing countries do not have adequate resources to easily facilitate fast,
two-way communication, which is important in an EWS. Sirens, warning flags, messenger
runners or even signal fires could be alternative communication systems for countries with
remote communities or low resources and infrastructure (The United Nations Office for
Disaster Risk Reduction, 2006). The most appropriate system for a particular country would
be implemented, however these modes of communication do not have the same capacity for
near-instantaneous dissemination. For example, it would be difficult for warnings spread via
messenger runner to be two-way and interactive with the source of the message. However this
issue could be combatted if more than one medium of communication was implemented, to
broaden the release channels as suggested in the Framework, creating a more sophisticated
communication system (The United Nations Office for Disaster Risk Reduction, 2006).
Extensive training may be required to ensure that these systems are reliable and understood by
the target audience. There is little point in lighting a signal fire if the target population believes
it to be a simple campfire, rather than the warning that would save their lives. The degree to
which the implementation of EWS is hindered by national and local access to adequate
resources would depend on the capacity of each specific country and its communities.
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Early Warning Systems: Economic Factors Enabling Implementation
A substantial economic factor enabling the implementation of EWS is the relatively low cost
involved in investment and maintenance for developed countries, like Japan and the USA. The
projected capital cost for the earthquake EWS in the West Coast of the USA is US$38.3 million,
with a further US$16.1 million required for operations and maintenance each year once the
system is fully established (Given et.al, 2014). Putting this into a New Zealand context and
using cost per square kilometre as a rough estimate, it would cost around NZ$17.07M in capital
costs to set up and NZ$7.17M for annual operations after this. These costs are not high enough
to be a significant disincentive to the implementation of EWS in New Zealand, especially when
compared to the $16.5b the government has contributed to the rebuild of earthquake-devastated
Christchurch since 2010 (The Treasury – New Zealand, 2015). Although a multi-hazard EWS
would likely have higher costs than an earthquake-specific system, it would nonetheless reduce
future damage from a disaster as people would have time to act to ensure this. For example, an
Oki computer chip manufacturing company in Japan had US$15M worth of damage during
two magnitude 6 earthquakes (Lee, 2013). After implementing an EWS that acted to isolate
hazardous chemicals and put robots into safe mode, the damage from the next two magnitude
6 earthquakes was only US$600,000. This evidences how EWS could create a significant
reduction of costs from a disaster on a national scale, in accordance with the goals of the Sendai
Framework (Association of Caribbean States, 2015). However, the projected cost estimate of
around NZ$63/km2 for setting up operations would be relatively expensive for poor and
developing countries. This would create a disincentive to invest in and develop EWS in their
country, hindering its implementation. As mentioned previously, for any country, availability
of funding must be coupled with strong political incentives to prioritise disaster risk reduction
policies, like EWS.
Conclusion
The process of implementing EWS is long and costly, particularly when the goal of the project
is long-term sustainability. Any viable system must be invested in, developed, maintained and
strengthened over a period of 10-20 years. It is a formidable commitment, but one that Priority
4 of the Sendai Framework for Action for Disaster Risk Reduction insists is an important one
to make in order to enhance disaster preparedness for response and to Build Back Better. The
inclusion of women and the disabled in discussions of disaster risk reduction is also a vital part
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of ensuring that the overall goals of the Framework are achieved; to reduce vulnerabilities and
losses related to disaster risk. There may be significant economic factors hindering the
implementation of EWS, like access to funding and resources, and barriers to information
dissemination. However, the relatively low cost for developed countries and the recognition of
the need for EWS at both national and local levels may both hold more influence over the
decision to invest in them.
References
1. Aldrich, D. P. (2012). Building resilience: Social capital in post-disaster recovery
Chicago: University of Chicago Press Books. Available at:
http://www.press.uchicago.edu/ucp/books/book/chicago/B/bo13601684.html
2. Association of Caribbean States. (2015). The Implications of the Sendai Framework for
Disaster Risk Reduction 2015-2030 for the Greater Caribbean Region. Association of
Caribbean States-Directorate of Transport and Disaster Risk Reduction. Available at:
http://www.acs-aec.org/index.php?q=disaster-risk-reduction/the-implications-of-the-
sendai-framework-for-disaster-risk-reduction-2015-20
3. Bhatt, M. (2015). Opinion: Gender-Sensitive Disaster Risk Reduction: What
Opportunities Exist after Sendai? The Climate and Development Knowledge Network
Available at: http://cdkn.org/2015/04/opinion-gender-sensitive-disaster-risk-reduction-
opportunities-exist-sendai/
4. Carby, B. (2006). Benefits of an Integrated Early Warning System: The Jamaican
Experience. The Office of Disaster Preparedness and Emergency Management, Jamaica.
Available at:
http://www.unisdr.org/2006/ppew/inforesources/ewc3_website/upload/downloads/Sympo
sium_PP%26E_07_Carby_126.pdf
5. Given, D.D., Cochran, E.S., Heaton, T., Hauksson, E., Allen, R., Hellweg, P., Vidale, J.,
and Bodin, P. (2014). Technical implementation plan for the ShakeAlert production
system—An Earthquake Early Warning system for the West Coast of the United States,
U.S. Geological Survey Open-File Report 2014–1097. Available at:
http://pubs.usgs.gov/of/2014/1097/pdf/ofr2014-1097.pdf
6. Kirbyshire, A. (2015). Opinion: What Next for the Sendai Framework for Disaster Risk
Reduction? Perspectives from South Asia, Climate & Development Knowledge Network,
April 21, 2015. Available at: http://cdkn.org/2015/04/what-next-for-the-sendai-
framework-for-disaster-risk-reduction-south-asia/
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7. Lee, J. J. (2013). How Do Early Warning Systems Work?. National Geographic News.
Available at: http://news.nationalgeographic.com/news/2013/09/130927-earthquake-
early-warning-system-earth-science/
8. McElroy, A. (2015). Inclusion Builds Resilience. The United Nations Office for Disaster
Risk Reduction, March 18th, 2015. Available at: http://www.unisdr.org/archive/43277
9. The United Nations Office for Disaster Risk Reduction. (2006). Developing Early
Warning Systems: A Checklist. The Third International Conference on Early Warning
(EWC III) hosted by the Government of Germany under the auspices of the United
Nations. Available at: http://www.unisdr.org/2006/ppew/info-
resources/ewc3/checklist/English.pdf
10. The Treasury – New Zealand. (2015). Budget 2015: Executive Summary: A Plan That’s
Working. Wellington: The Treasury of New Zealand. Available at:
http://www.treasury.govt.nz/budget/2015/bps/01.htm
11. United Nations-United Nations Office for Disaster Risk Reduction (2015). Sendai
Framework for Disaster Risk Reduction 2015-2030. Available at:
http://www.preventionweb.net/files/43291_sendaiframeworkfordrren.pdf
12. United Nations News Centre. (2015). Sendai: Early Warning Saves Lives, But
Communities Need Targeted, Useful Information. Available at:
http://www.un.org/apps/news/story.asp?NewsID=50331#.VleYO9IrKUk
13. Wood, C. (2014). Is Mexico’s Earthquake Early Warning System a Model for the World?
Emergency Management, April 30, 2014. Available at:
http://www.emergencymgmt.com/disaster/Mexicos-Earthquake-Early-Warning-
System.html
14. World Meteorological Organisation. (2015). Multi-Hazard Early Warning Systems.
Available at:
https://www.wmo.int/pages/prog/drr/projects/Thematic/MHEWS/MHEWS_en.html
NZREF Vol.4, 2015
16
Michael SUTTON3
Abstract:
Auckland’s property market has been the subject of much political and economic debate in
New Zealand. This has primarily focused on the affordability of housing in Auckland, and the
impact a crash could have on household balance sheets in New Zealand. One less explored area
is the risk such a decline poses to the New Zealand banking industry, given that the industry is
so heavily reliant upon the confidence of consumers and firms to borrow. This essay looks at
bank risks associated with the Auckland housing market, and whether attempts by regulators,
and the banks themselves to mitigate these risks are currently working, and if they would be
effective in a crash.
3 Email address: [email protected]
The Challenges Auckland’s Housing Market
Presents to New Zealand’s Banking System
NZREF Vol.4, 2015
17
Introduction
The New Zealand Banking sector faces a number of macro-economic risks when lending to
households and investors. If Auckland house prices continue to move away from measures of
fair value such as household income and rental return ratios, credit default, liquidity and
correlated risks will increase. A price correction would undermine bank profitability as
individuals and institutions become more wary of borrowing and the velocity of circulation of
capital around the system slows. Banks must be aware of these factors when making decisions
about capital allocation and formulating risk mitigation strategies.
Credit Risk
The greatest risk to banks from a downturn in Auckland house prices is the loss of principal or
interest repayments from mortgages. This risk has the potential to undermine the financial
stability and profitability of banks, as when default rates are greater than expected banks will
be forced to downgrade profit forecasts, increase reserves and in worst cases face liquidity
shortages. According to Jang et al. (2013), all of New Zealand’s four major banks are carefully
managing their credit risks and have adequate capital requirements to prevent credit defaults
bringing down the bank. To assess this risk it is necessary to look at fair value measurements
like prices relative to incomes, and prices relative to rental returns, to assess whether Auckland
borrowers are likely to be able to repay debt taken on to purchase residential properties. As
exogenous short term factors such as increased net migration and increased foreign investor
buying cannot be relied upon as long-term price drivers.
NZREF Vol.4, 2015
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2.1 Price to Income Ratios
Figure 1. Statistics New Zealand (2015) & Real Estate Institute of New Zealand (2015). Auckland house prices are growing
at a rate far exceeding household income growth, meaning many new borrowers are resorting to increasingly risky mortgages
to buy property or are not buying property at all because it is too expensive relative to their level of income.
The data shows that as of June 2015 the average Auckland house price was 9.59 times the
average Aucklander’s income, this was nearly double that of the average house price to income
ratio of New Zealand which was 6.16, which is significantly inflated by the high prices of
Auckland. Auckland house prices divergence from the real incomes of Auckland households
increases the risk of default, as it takes a high proportion of household disposable income just
to pay back their mortgages. This makes it more likely in a downturn that New Zealand banks
would have to take haircuts on the original amounts that they loan out to the borrowers, or sell
the collateral to regain their initial principal. Fallow (2015) states that the Auckland property
market has grown at a rate superior to the growth of economic activity in the region, meaning
that there is increased stress on households to meet ever higher mortgage repayments.
0
2
4
6
8
10
122003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015M
edia
n H
ouse
Pri
ce/M
edia
n
House
hold
Inco
me
(x)
Figure 1: Property Prices relative to Income
New Zealand Auckland
NZREF Vol.4, 2015
19
2.2 Price to Rental Return Ratios
Figure 2. Real Estate Institute of New Zealand (2015) & Department of Building and Housing (2015). Similar to house price
to income ratios, price to rent ratios indicate an increasingly volatile market in Auckland where prices paid reflect the desire
for capital rather than rent-based returns.
Price to rental return ratios are similar to a Price to earnings ratio on the stock market, as they
allow comparisons between where house prices are relative to the underlying income that can
be derived from them. Growth in the ratio over time can be seen as the market moving away
from fair value, as you can see with the Auckland rate moving from 17.17 times income to
29.30 times by 2015. Spencer (2015) says investors speculating on capital returns are distorting
market price signals, and present a substantial risk to banks as if capital growth of property
slows or even declines the rental income will not be there to help investors meet repayment
obligations (Spencer, 2015). This is a substantial risk to banks as it will lead to more investors
defaulting in a downturn, as their positions in general are more largely based on the speculation
using the banks’ capital rather than long term rental returns.
Liquidity Risk
If mortgages were to begin to go bad as a result of an Auckland housing downturn it would be
difficult for banks as it takes a long time to foreclose a property and liquidate the asset.
Mortgages make up a large proportion of the banks overall lending portfolio that it may be
difficult to foreclose many houses at once, because liquidating these assets in a downturn has
the potential to damage the value of other property and worsen the problem. Standard & Poors
said in its August credit report on NZ banks that Auckland makes up such a large proportion
0
10
20
30
402003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Med
ian H
ouse
Pri
ce/M
edia
n
Ho
use
Ren
t (x
)
Figure 2: Property Prices relative to Rent
New Zealand Auckland
NZREF Vol.4, 2015
20
of the economy, that any downturn in Auckland housing would hurt national consumer
confidence, business confidence, real incomes and employment (McBeth, 2015). However
they did indicate that liquidity is less likely to be an issue, because New Zealand’s four major
banks have stable Australian parent companies. Bank runs or liquidity shortfalls could occur if
New Zealand consumers become fearful of a house price collapse, but would likely only affect
smaller banks and lending institutions unless it became a Trans-Tasman phenomenon.
Systematic Risk
Significant correlated risks exist in the New Zealand banking system as banks trade with each
other, and lenders have their own lenders they borrow from. If property prices were to fall it
would set off a chain reaction that would also impact other assets and types of credit to New
Zealand households and firms. Reserve Bank of New Zealand (2014) conducted a banking
stress test to assess a number of different scenarios and found that all of New Zealand’s major
banks had adequate capital ratios to withstand a national housing drop of 30-40% and some of
the associated risks, but would suffer substantial loan losses and asset impairment (Reserve
Bank of New Zealand, 2014). This is because the average Auckland property owner
experiencing a decline in their property value is likely to feel less wealthy, therefore likely to
spend less and increase their rate of savings. This in turn means that the firms they buy goods
and services from are likely to perform worse, which would then decrease the amount they
have to spend on purchasing property, and the amount of goods and services they buy from
suppliers scattered throughout New Zealand and the rest of the world, creating a negative
spiralling effect.
Bank Risk Modelling
Assumptions made on default rates and risk weightings that may be appropriate under normal
economic conditions may be inappropriate in the case of a severe correction due to chain
reaction. Adolphus. T. (2011) argues that in the 2008 financial crisis bank financial models left
less provision for failing loans than what actually occurred, because they failed to factor in
exogenous shocks to the system and that such shocks are not always one-off events but rather
manifest themselves as a series of events (Adolphus. T., 2011). Stress testing is one way of
managing this risk, but may not always account for the unpredictable or flow on impacts.
NZREF Vol.4, 2015
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Financial Stability
A crash in the Auckland property market would have a large impact on the financial stability
given its strategic importance as one of the largest single stores of wealth in New Zealand.
Reserve Bank of New Zealand (2015) in their latest financial stability report says that the
current financial position of New Zealand Banks in terms of liquidity and funding is strong,
however sudden changes in underlying market conditions such as a fall in Auckland house
prices could restrict their access to foreign capital (Reserve Bank of New Zealand, 2015). It
would damage consumer, business and investor confidence in the New Zealand economy
slowing the velocity of circulation of capital flows around the system, which would mean
reduced profits for businesses, who would in turn be forced to cut wages paid to workers.
Bordo, Hargreaves, & Kida (2011) say that property crashes undermining bank stability is
nothing new, given that in 1990 Bank of New Zealand was recapitalised at a cost of 1% of
GDP, as the result of a crash in the commercial property market that had been spurred on by
excessive bank lending. This lesson shows that banks are not immune to the underlying markets
they lend to, particularly if borrowers go into positions negative equity or bankruptcy (Bordo
et al, 2011). If the value and liquidity of their collateral declines to an extreme extent then they
can face significant shortfalls that can bring down the entire institution.
Loan to Value Ratios
In August 2013 the Reserve Bank introduced loan-to-value ratio restrictions to mitigate and
prevent the risk of default for both borrowers and lenders alike. Wheeler (2013) said that the
Reserve Bank introduced loan-to-value ratio of 20% on existing houses as the level of house
price inflation was exceeding the level of general inflation, while new build homes were
exempt as they contributed to increasing supply. He believes the over-valued housing market
is a substantial risk factor to household balance sheets as housing makes up ¾ of all New
Zealand household assets. The macro-prudential tool limited the amount that banks could lend
relative to the lender’s deposit, effectively meaning that borrowers had to prove their credit-
worthiness by saving up a substantial deposit. The tool was recently modified to specifically
focus on the Auckland market, with property investors in Auckland now requiring a 30%
deposit in most circumstances, while other Auckland and New Zealand buyers will continue to
require at least a 20% deposit in most cases. Wong, Fong, Li & Choi (2011) says that empirical
evidence shows the use of loan to value ratios have been successful globally in reducing
NZREF Vol.4, 2015
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systematic risk and preventing credit defaults in the banking sector, but they have the drawback
of reducing some households’ liquidity (Wong. et al. 2011). The use of Loan to Value ratios in
New Zealand has done little to cool the Auckland property market over the past two years as
prices have continued to climb. But it has improved financial stability as the policy forces banks
to lend to higher quality borrowers and incentivises borrowers to exercise greater fiscal
discipline.
Profitability
Bank profits are driven by taking, managing and reducing risk. Banks are constantly faced with
a balance sheet trade-off between how much risk they take on, and the margin of safety they
leave for adverse events such as crashes in housing, equity or employment markets.
6.1 Net Interest Income
Figure 3. Australian and New Zealand Banking Group (2014), Bank of New Zealand (2014) & Westpac New Zealand (2014).
Disclosure Statements from New Zealand’s four major banks show that their primary income generating activity was net
interest income which made up 75% of operating income, whereas other operating activities like trading and funds
management made up just 25%.
Bank profitability primarily relies on making a margin between the interest paid on its liabilities
and the interest received from its assets. In order to maximise this profit the bank uses leverage
to amplify the possible gains. DeYoung & Rice (2004) say that interest income is a significant
Net Interest Income;
7,624; 75%
Other Income; 2,574;
25%
Figure 3: Operating Income for New Zealand's
Four Largest Banks in 2014 (NZD m)
NZREF Vol.4, 2015
23
way that banks make profits, but that it also depends on the particular bank’s risk tolerances
and focus, whether that be wholesale, retail or investment banking (DeYoung & Rice, 2004).
For New Zealand’s largest banks more focused on the retail business, so long as lenders are
capable of paying the interest back on their mortgages and depositors trust the bank as a safe
place to keep their savings, banks will remain stable and profitable.
6.2 Diversified Lending Portfolios
Figure 4. Australian and New Zealand Banking Group (2014), Bank of New Zealand (2014) & Westpac New Zealand (2014).
New Zealand banks hold diversified lending portfolios with a mixture of housing and non-housing assets to spread risk across
different areas of the economy.
Banks hold diversified lending portfolios to smooth their profits through different times in the
economic cycle. New Zealand’s largest four banks hold $160b in housing liabilities and $114b
in non-housing liabilities, meaning they have some diversification, but are still very much
focused on housing. Bennett (1999) argues that although banks can reduce credit risk by
lending across a range of areas, but they should focus on lending to borrowers where they have
informational advantages, and let bank shareholders diversify their own portfolios if they wish
to reduce risk (Bennett, 1999). Even though banks can reduce credit risk by diversifying the
types of assets they hold, in a downturn they are always liable to falling profits due increased
numbers of defaults. Which can occur whether they are heavily invested in the property market
or not.
Housing;
160,685; 56%
Non-Housing;
114,269; 39%
Overdraft; 2%
Credit Card; 2% Other; 1%
Figure 4: Lending by New Zealand's Four
Largest Banks in 2014 (NZD m)
NZREF Vol.4, 2015
24
6.3 The Relationship between Bank Profits and House Prices
Figure 5. Statistics New Zealand (2015) & Reserve Bank of New Zealand (2015) shows that the indexed value of real incomes
and median house prices are correlated. Rising asset prices in particular housing are a key driver of confidence to borrow
and by extension bank profits.
New Zealand Bank Profits have grown at a steady rate similar to the national house price
average, apart from one outlier in 2009 when Bank Profits fell substantially due to the crash in
global equity markets. Moody's report says that in the short run, recent cuts in interest rates
have taken pressure off households and put New Zealand banks in a stronger profit making
position in the mortgage market (Yu & Long, 2015). However in the long term a potential
decline in investor confidence as a result of depreciating Auckland house prices, would reduce
new lending which banks rely upon to make strong profit margins and generate long-term
business. With reduced new lending and less confidence to spend, the velocity of circulation
of capital around the system would decline reducing New Zealand banks opportunity to clip
the ticket on not only lending products like mortgages, but also other forms of credit like
personal loans, business loans and credit cards.
Conclusion
The role of banks in society is to manage risks. Loans for housing, particularly in Auckland
have their own unique set of risks and challenges, which banks must mitigate. Their financial
stability is always a balancing act between managing risks and maintaining profitability. Given
Auckland’s high level of importance to New Zealand’s economy a sharp decline in house prices
0
500
1000
1500
2000
2500
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Ind
ex V
alue
(20
03
= 1
00
0 B
.P.)
Figure 5: Bank Profits and House Prices
NZ Median House Price NZ Registered Bank Profits
NZREF Vol.4, 2015
25
there would reverberate around the New Zealand economy, in the process destabilising the
banking and financial system. Bank profits are driven primarily by housing interest margins
substantially from Auckland. Meaning New Zealand banks’ success is heavily tied to the
appreciation of borrowers’ assets such as houses, which make up ¾ of all New Zealand
household assets. The confidence of borrowers and liquidity to sell collateral when needed,
would all be eroded by a decline in Auckland house prices, which would diminish the ability
for banks to make profits and threaten their financial stability.
References
1. Adolphus, T. J. (2011). Modelling financial fragility and bank profitability in an
international Context. International Journal of Business Insights and Transformation. Vol.
4 Issue 2. Available at:
http://web.a.ebscohost.com/ehost/pdfviewer/pdfviewer?sid=c527b901-3d8d-45d4-a21b-
8c23390934fb%40sessionmgr4005&vid=0&hid=4209
2. Australian and New Zealand Banking Group. (2014). ANZ Bank New Zealand Limited
Annual Report and Registered Bank Disclosure Statement. Available at:
http://www.anz.co.nz/resources/d/5/d58c2ed9-5dc7-4799-b812-974c230d0832/ANZB-
DS-Sep14.pdf?MOD=AJPERES
3. Bank of New Zealand. (2014). Disclosure Statement, for the year ended 30 September
2014. Available at : https://www.bnz.co.nz/assets/about-us/financials/pdfs/bnz-financial-
disclosure-statement-2014-09-30.pdf
4. Bennett, P. (1999). Portfolio theory and bank lending: avoiding concentrations of credit
risk through strategic diversification. Journal of Lending & Credit Risk Management.
Volume: 81(11). 64. 81(11). 64. Available at: https://www.questia.com/read/1G1-
55905493/portfolio-theory-and-bank-lending-avoiding-concentrations
5. Bordo, M., Hargreaves, D. & Kida, M. (2011). Global shocks, economic growth and
financial crises: 120 years of New Zealand experience. Financial History Review. 18(3).
331-355. Available at: https://ideas.repec.org/p/nbr/nberwo/16027.html
6. Department of Building and Housing. (2015). Mean New Zealand Rental Incomes.
Available at : https://tenancy.govt.nz/rent-bond-and-bills/market-rent/
7. De Young, R. & Rice, T. (2004). How do banks make money? A variety of business
Strategies, Economic Perspectives. Issue Q IV. Available at:
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http://econpapers.repec.org/article/fipfedhep/y_3a2004_3ai_3aqiv_3ap_3a52-
67_3an_3av.28no.4.htm
8. Fallow, B. (2015, March 2014). Auckland’s real estate fail. New Zealand Herald.
Available at:
http://www.nzherald.co.nz/brianfallow/news/article.cfm?a_id=16&objectid=11417071
9. Gaynor, B. (2015). Challenge to not let housing boom turn into a bubble. New Zealand
Herald. Available at:
http://m.nzherald.co.nz/opinion/news/article.cfm?c_id=466&objectid=11449471
10. Jang, K. & Kataoka, M. (2013). New Zealand Bank’s Vulnerabilities and Capital
Adequacy, IMF Working Paper WP/13/7. Available at:
https://www.imf.org/external/pubs/ft/wp/2013/wp1307.pdf
11. McBeth, P. (2015). Rising Auckland house prices weigh on NZ lenders. Scoop Business
August 2015. Available at: http://www.scoop.co.nz/stories/BU1508/S00501/rising-
auckland-house-prices-weigh-on-nz-lenders-sp-says.htm
12. Real Estate Institute of New Zealand. (2015). REINZ Median house price. Available at:
http://www.interest.co.nz/charts/real-estate/median-price-reinz
13. Reserve Bank of New Zealand. (2015). Financial Stability Report: November 2015.
Available at: http://www.rbnz.govt.nz/financial_stability/financial_stability_report/fsr-
nov2015.pdf
14. Reserve Bank of New Zealand. (2014). Financial Stability Report: November 2014.
Available at:
http://www.rbnz.govt.nz/financial_stability/financial_stability_report/fsr_nov14_boxa.pdf
15. Spencer, G. (2015). Investors adding to Auckland housing market risk. Reserve Bank of
New Zealand. Available at:
http://www.rbnz.govt.nz/research_and_publications/speeches/2015/investors-adding-to-
auckland-housing-market-risk.html
16. Statistics New Zealand (2015). Linked employer-employee data-information releases.
Available at: http://www.stats.govt.nz/browse_for_stats/income-and-
work/employment_and_unemployment/linked-employer-employee-data-info-
releases.aspx
17. Westpac New Zealand. (2014). Westpac Annual Disclosure Statement. Available at:
http://www.westpac.co.nz/who-we-are/about-westpac-new-zealand/westpac-disclosure-
statements/
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18. Wheeler, G. (2013). Why Loan-to-Value ratios were introduced. Reserve Bank of New
Zealand. Available at: http://www.rbnz.govt.nz/news/2013/5478390.html
19. Wong, T. C., Fong, T., Li, K. F., & Choi, H. (2011). Loan-to-value ratio as a macro
prudential tool-Hong Kong's experience and cross-country evidence. Systemic Risk,
Basel III, Financial Stability and Regulation. Available at :
http://dx.doi.org/10.2139/ssrn.1768546
20. Yu, D., Stephen. L. (2015). New Zealand banking system outlook stable on strong bank
Fundamentals, despite weaker economic growth. Moody’s Investors Service Available
at: https://www.moodys.com/research/Moodys-New-Zealand-banking-system-outlook-
stable-on-strong-bank--PR_331567
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Terence TONG4
Abstract:
It is generally acknowledged that financial crises are crises of governance. Two distinct views
have emerged in the aftermath of the crisis, one view suggests there were fundamental flaws
in the Asian financial markets, while the alternative view proposes that the Asian Financial
Crisis was simply due to a severe case of bank panic that spread across multiple countries. This
paper explores both views and attempts to uncover the causes that triggered a region wide
financial crisis. Among the combination of bank panic, brought by structural imbalance in the
financial sector and inadequate policy response, surprisingly, Taiwan did not suffer serious
economic crisis that seem to have impacted to other Asian Tigers.
4 Email address: [email protected]
The Causes of the 1997 Asian Financial Crisis
and How Taiwan was immune to it
NZREF Vol.4, 2015
29
Introduction
Much has been written on the Asian Financial Crisis (AFC) and what has been revealed does
not provide a definite answer to the causes of the crisis. Despite a great deal of effort having
been devoted to trying to understand its causes, two distinct views have emerged in the
aftermath of the crisis.
According to one view, there were fundamental flaws in the Asian economies, the crisis
reflected structural and policy distortions in the Asian financial systems that were simply
masked by rapid growth. Weaknesses in the failure of government to upgrade bank supervision
and regulation triggered the currency and financial crisis in 1997. Fundamentally, these weak
economic conditions when combined with market overreaction contributed to the plunge of
exchange rates that were more severe than anticipated.
While the alternative view is that there was nothing characteristically wrong with the Asian
financial system which historically has been characterised by robust rates of economic growth.
The severity and speed of the contagion should not be attributed to deterioration in the
fundamentals alone, but instead were due to the sudden reversals of investor attitudes about the
future economic prospects of the crisis which was somewhat reinforced by the poor policy
response of the International Monetary Fund (IMF).
It is interesting to note that Taiwan appears to have escaped from such economic chaos, having
only suffered minor decline in growth rate. The reasoning behind such strong economic and
financial stability can be attributed to healthy macro fundamentals and prudent financial
policies that were supported by high level of foreign currency reserves and low levels of
corporate debt.
In this critical review, we attempt to pinpoint the root of the AFC through both the fundamental
and self-fulfilling beliefs and examine how Taiwan was immune to the Asian Financial Crisis.
The rest of the paper is organised as follows: A broad overview of the Asian Financial Crisis
is provided in section 2, section 3 and 4 explore the two approaches that best attempt to explain
the causes of the AFC, and finally section 5 focuses on Taiwan and how it managed to escape
the economic crisis.
NZREF Vol.4, 2015
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Summary
Operating in an environment of high economic growth since the early 1980s, most of East Asia
enjoyed high rates of saving and investment, export growth, and positive investor confidence.
The onset of financial crisis in the mid-1990s took everyone by surprise and went far beyond
the usual consequences of speculative currency devaluation. This one was more difficult to
predict and the least anticipated financial crisis.
The search in for the culprit points to Thailand which had disquieting signs leading up to the
crisis. By early 1997, markets experienced a slowdown and Thailand’s current account deficit
rose to an alarming level. With low cost export competitors from China, this foreshadowed
lower profits in Thailand’s manufactural sector and prompted investors to have short positions
against the Baht.
Much of the economic activities throughout East Asian were supported by large capital inflows
of international lending, the relatively high returns in perceived low risk Asian economies made
it an attractive investment location. However, the excessive reliance on foreign resources
exposed those countries to high vulnerability especially when accompanied by pressures in the
Baht currency. Thai central bank was unsuccessful in defending the Baht against the US dollar
which resulted in Baht to depreciate rapidly. The events led to a wave of currency depreciations
and stock market deterioration among neighbouring countries in Southeast Asia.
Eichengreen (1998) explains the reasoning why the crisis was largely unanticipated was
because those countries infected by the contagion had very little economic, financial, and
political commonality with Thailand other than physical proximity. Although a small number
of market observers were concerned, most did not see the surge in private capital inflows as a
warning that the financial market was becoming structurally vulnerable or vulnerable to a
financial panic. Many expected the downfall of Thailand to be an isolation event. This
contagion can be attributed to the lending behaviour to East Asia, international investors were
happy to respond to the falling interest rates in their domestic markets and lend to the Asian
economies despite not having a transparent overview of the real situation of the true risk.
Borrowing banks, on the other hand, welcomed the large inflow of international lending that
provided access to cheaper foreign markets. Although this relationship appears to satisfy both
parties, there is an underlying problem due to the mismatch of funds maturity. The fundamental
NZREF Vol.4, 2015
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of banks’ business model lies in borrowing banks accepting deposits with short maturities to
finance loans with long maturities, and in the event of a bank panic, this balance is under threat.
To maintain financial stability in the economy, the IMF acted as an enforcer to monitor and
promote sustained economic growth in Asia and the world. (International Monetary Fund,
1998). Instead, many disgruntled countries were not satisfied towards IMF handling of the
Asian Financial Crisis, including Dr Mahathir Malaysian Prime Minister. The IMF’s inability
to diagnose the causes of the crisis correctly led to many implementation and supported
programmes put in place to be impractical, which some observers believed contributed to the
severity of the crisis. In fairness, although the practicality of IMF’s response remains
questionable, like many others, IMF did not foresee the severity of the crisis.
While the facts on the onset of the Asian Financial Crisis and the sequence of events that
followed appears to be consistent among academic literatures, the underlying causes of the
crisis remains ambiguous and subject to much discussion.
Causes of the Crisis
3.1 Fundamental Belief
In the eyes of IMF, the AFC is seen to be associated with countries whose governments lacked
the political and economic policies to defend their currencies. Eichengreen (1998) believed that
years of gradual accumulation of structural imbalances eventually led to the crisis. IMF stresses
that fundamental flaws were always present in the Asian economies and that they were
common knowledge to investors that were perceived well before the crisis, yet little was done
by the Asian financial markets to minimise the consequences of these flaws. One example was
the poor quality bank assets the Thai accumulated in the months leading up to the crisis, it was
clear to the investors that the problems were getting worse and the probability of a severe
financial crisis was increasing. The fact that investors had short positions against the Baht and
not against other East Asian currencies suggests how they perceive the situation. Burnside et
al., (2001) provided evidences that implied that the Thai devaluation could have been foreseen
over two years before the devaluation occurred.
Most of the problems arise from Asian countries’ ability to attract significant capital inflows
without the appropriate safeguards in place to defend their currencies. This weakness in
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governments, in turn, enhance the vulnerability of the financial system. To pinpoint the causes
of the crisis, the fundamental question lies behind how the contagion countries allowed
themselves to get into such predicament in the first place.
One crucial blunder was the weakness of the financial systems in these crisis countries. The
failure to upgrade bank supervision and regulation is often widely stated among the major
causes of the AFC, and these policy errors have largely encouraged excessive borrowing
resulting in high risk borrowing and lending. Bustelo (1998) and many others have widely
criticised that exchange rate policies were to blame, and that the volatility of capital flows is
the result of incorrect choices of floating and fixed exchange rates. It is worth mentioning that
evidences provided by Velasco et al. (2000) from United Nations suggested that the probability
of the currency crises are as likely to occur under flexible exchange rates as under fixed
exchange rates, these policies are indifferent in preventing volatility of capital flows. Thus, the
main policy error relates to financial supervision and regulations.
Fons (1998) states that there was a lack of transparency among bank balance sheets, and often
lengthy delay before banks releases financial reporting and revealed information about their
nonperforming loans. This reflects the failure of government supervision to ensure banks
follow rigorous auditing practices, and in turn, this allows banks to distinguish good credit risks
from bad ones. Without transparency, it made it difficult for government regulators to focus on
the weaknesses to strengthen the financial system. Instead, most diseased banks in these crisis
countries were allowed to survive and contaminate the entire bank system.
Although prior to the AFC, East Asian economies did have some regulatory and supervisory
systems in place, these were usually ineffective in preventing the excessive build-up of risk
and fragility in the financial sector. Rajan and Zingales (1998) blames this to crony capitalism
economies among Asian countries, and that these relationship-based systems often result in
inefficiency in the financial market. The inability of banks and government officials to abide
to these regulations expose them to risks that should have been minimised. Instead, this led to
problems where well-connected borrowers were lent funds when it did not meet business
criteria and poorly managed firms were able to acquire loans subject to meeting government
policy objectives. This resulted in excessive risk taking and bank loan decisions being made
for political reasons rather than economic rationales which together contributed to the weak
corporate governance. The consequence of this type of credit allocation is massive losses. Yet
banks have a lack of incentives for effective risk management due to moral hazard in that many
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financial intermediaries feel that government authorities would be compel to guarantee the
foreign liabilities of the banks.
Another element of the AFC is the short term nature of the foreign lending to Asian banks, this
has been widely criticised due to the fact that accumulating large stocks of short term debt that
needed to be regularly rolled over exposes significant vulnerability. To support the economic
growth and their current account deficits, the Asian economies needed to attract ongoing capital
inflows from foreign investors. This soon became a problem when the confidence in the market
was disturbed, and investors were not willing to renew their maturing loans unless they were
compensated with higher interest rates. In this case, it was the misjudgement of return and risks
by both lenders and borrowers that prevented the economy from profitably utilise the capital
inflows. Ultimately, this was the consequence of ineffective risk management by the
government.
The third source of Asia’s vulnerability was the fact that borrowers did not hedge against the
currency risk that was so detrimental to the financial market when the risk was not managed.
Akyuz (2000) believes this was due to the history of stable exchange rates and also given the
favourable economic environment at the time, banks see very little incentive to hedge and
insure themselves against its depreciation. The continued growth in exports was expected to
sustain, and this in itself was supposed to be sufficient in protecting against currency
devaluations. Thus, based on investor and borrower’s beliefs, they were lured into a false sense
of security that was realised when export growth decelerated. When the exchange rate fell, it
became apparent that it would be difficult to meet their current obligations given the
unfavourable foreign exchange costs. While continued short-term foreign borrowing could
have provided some cushion against the temporary financial difficulties, this unhedged foreign
exposure would also left firms extremely susceptible to future change in exchange rates.
3.2 Self-Fulfilling Belief and Malaysia’s View
Although many market observers and analysis have found microeconomic and financial causes
for bank crises, there are also many others that view that there were nothing inherently wrong
with the Asian financial system. Gavin and Hausmann (1996) emphasis this by using the
analogy that chains break at their weakest link, but it is the tension on the chain, as much as
the weakness of the weakest link that causes the failure. Thailand was the sole culprit that
experience financial difficulties, but it was the bank panics among East Asian countries that
cause the financial crisis – a conclusion that is also echo by Gordon (1988). Even well managed
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banks are subject to bank run, this is due to banks’ business model in which they accept deposits
with short maturities to finance loans with long maturities. This mismatch maturity will always
be a vulnerability for banks, there are always constant risks that all investors withdraw their
funds from a given bank simultaneously, as in the case of a panic.
Given this self-fulfilling belief is the main catalyst to the financial crisis, investor sentiment
becomes important for generating a self-fulfilling crisis. According to this explanation, the
crisis is a reflection of sudden reversals of investor attitudes and beliefs about the future
economic prospects of the crisis country. Fundamental flaws in the Asian economies only
played a small role in the AFC but ultimately this is due to investors switching from optimism
to pessimism about future economic prospects that fuelled the panic. Halcomb and Marshall
(2001) investigates whether the AFC was foreseen by investors, and any evidences that it was
foreseen would see markets react prior to the crisis. Like financial crisis, in principle, it is also
difficult to foresee any shift in sentiment by the financial markets. As mentioned above, it was
the stream of capital inflows from foreign investors that made the Asian economy vulnerable
to a financial panic. Following the reversal in beliefs led investors to pull their investment out
of East Asia, causing the significant economic downturn.
Malaysia stood out as a country that strongly believed that IMF helped worsen the AFC, and
refused IMF assistance and advice. Unlike other theories mentioned above on what caused the
AFC, the Malaysian government pinpoints the way IMF’s responded to the crisis and that if it
had acted appropriately in the first instant, the financial crisis may have been contained within
Thailand. Having contributed in many ways to the development of the crisis, the IMF treated
all crisis countries as if they could not meet their balance of payment obligations, and
implemented policies for them to make loan arrangements. However, this was not the case.
Many Asian governments were generally in-fact running budget surplus, yet they were being
treated by IMF as running budget deficits requiring them to cut expenditures, a recessionary
policy that deepens the economic slowdown.
It was soon clear that IMF macroeconomic strategy was not working, and the Malaysian
government worked out a solution of their own. Despite many other countries requested
financial assistant from the IMF and complied with IMF conditionality, the terms were not
acceptable to Malaysia and they imposed temporary capital controls as a crisis measure to
eliminate speculative trading in its currency. In hindsight, Malaysia’s policy was a success and
it generally suffered less severe economic consequences than other countries embroiled in the
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AFC. (Yen Ping, 2009). There are no literature that concludes that AFC could have been
prevented if IMF was able to diagnose the crisis correctly and implemented the policy
appropriately. One possible reason for the lack of study on this topic is that no firm conclusions
could have been drawn from comparison since capital controls were only introduced by the
Malaysian government long after the currency had devalued. Mahathir’s economic approach
during the AFC has won praises for realising the flaws in the IMF policies, and it is satisfying
to know that the former World Bank Chief Economist acknowledged in 2011 its mistakes on
how it approached the financial crisis.
While the two views are not mutually exclusive, their policy implications vary greatly. In my
view, it was a combination of bank panic, brought by structural imbalance in the financial
sector and inadequate policy response that triggered a region wide financial crisis. Although
there are other underlying causes for the financial crisis, including overinvestment in real estate
and unnecessary ventures, the impact of these were vastly disproportionate compared to the
trio causes that I believe ultimately led to the AFC.
How Does Taiwan Fit Into This?
One way that Taiwan differentiates itself from the rest of the East Asian countries is its political
stance in that Taiwan is self-sustaining, and democratically-elected its government
independently from Mainland China and its own economy. However, this characteristic alone
is not sufficient to exempt itself from the contagion.
It was surprising to see Taiwan’s surrounding countries infected by the contagion yet they have
no commonality other than physical proximity. Of all the affected countries, some like
Singapore and Malaysia did significant amount of trading with Thailand, while others like
Indonesia and Hong Kong were the complete opposite and traded practically nothing there.
Some countries depended heavily on exports of primary commodities, while others
manufactured and sold technological products (Eichengreen, 1998). There weren’t any
noticeable pattern as to why a particular country was infected. Given Taiwan’s increasing
bilateral trading with other East Asian economies, it appears its economy was inevitable in
becoming involved in the financial turmoil. However, somehow Taiwan managed to weather
the AFC and was able to cope more successfully than most other economies in East Asia.
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One particular evidence that Taiwan remains unscathed and differ among other crisis countries
is that the financial crisis impact on Taiwan’s GDP growth, which remains surprisingly high
and only suffered minor decline in growth rate. This can be attributed to its current account
surplus and strong economic fundamentals that contributed to the stability of its currency.
Graphs from Chen, Y (1998) show that Taiwan had huge foreign reserves that were more than
three times over its external debt allowing its government to defend the unexpected speculative
attacks. It was also one of the only East Asian countries to have a current account surplus. One
thing that only Taiwan among the East Asian countries appear to realise is that while large
inflow of foreign capital stimulates the domestic economy to grow, it also provides opportunity
for speculative behaviour by foreign investors. Any movements of large amount of funds in a
short time period makes the entire economy susceptible to a financial crisis. As if the Taiwan’s
government was anticipating the AFC, it was well prepared and enforced strict restrictions on
the inflow of short term foreign capital. As a result, it maintained healthy macro fundamentals
that were supported by a high level of foreign currency reserves and low levels of corporate
debt. This limits the range of channels for foreign speculators to take advantage of the domestic
capital markets, and thus lessening the magnitude of uncontrolled capital market.
Although Taiwan has not completely isolated itself from the fallout of the East Asian currency,
its economy was significantly less affected than most others in the region. Chen (2000) credited
the fact that Taiwan was only negatively impacted due to the fact that it incurred a loss of
international investor confidence simply by being positioned in the region.
The characteristics that lead to Taiwan’s success can be pinpointed to current account surplus,
abundant foreign exchanges, and sound economic policies. This view was echoed by the World
Bank’s study of East Asian economic miracle and factors which contributed to Taiwan’s
economic success. Coincidentally, these were also the identical characteristics lacking in the
crisis countries. This evidence favours the argument that there was an element of fundamental
flaws in this crisis.
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Conclusion
After every financial crisis, as part of risk management, the global community reflects on what
needs to be done to mitigate the probability of future crises. The analysis of the Asian Financial
Crisis is a challenging but necessary task. The AFC has divided the community into two distinct
views on what caused the financial crisis, the fundamental view and the self-fulfilling beliefs.
However, there is usually some level of consensus about how a particular financial crisis begin
and ripple through the economy which very quickly develop into a global economic crisis.
The Asian crises highlight the importance of bank supervision and regulation, transparency
among bank balance sheets, and long term maturity of debt to hedge against currency risk.
However, the self-fulfilling belief tried to show that these were not the main culprits, except in
Thailand where it demonstrated economic difficulties before the onset of the crisis. Instead, it
focused on financial panic and IMF’s crisis prevention responses to be the main contributor to
the financial crisis. The fact that Taiwan was able to differentiate itself from the rest of the
crisis countries can be contributed to their macro fundamentals and policies, and any negative
consequence was likely due to investor’s perception of Taiwan by being located in the region.
While there are many literatures with different views on the factors to be blamed for the AFC,
there can be little doubt that IMF did not perform a central role in crisis management.
The lack of policy oversight prior to the onset of the crisis turned the withdrawal of foreign
capital into a financial panic to the extent that it was no longer reversible. Although we can all
agree that an intensive review of IMF is well needed, perhaps it should open its door for the
wider international community to address global economic and financial problems in the future.
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