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Asian Collapse as Model for Impending U.S. Economic Collapse

Fiscal Sustainability and Contingent Liabilities from Recent Credit Expansions in South Korea and Thailand

Diego Valderrama


Economist Federal Reserve Bank of San Francisco

Economic Review 2005:  An annual publication of the Economic Research Department, Federal Reserve Bank of San Francisco 

While South Korea and Thailand had relatively sustainable fiscal policies prior to the Asian crisis, the long-term cost of the bailout of their financial sectors amounted to an estimated 30 to 40 percent of output, which was largely financed by public borrowing. The recent credit expansions in South Korea and Thailand have created new contingent liabilities for the gov­ernments of the two countries. This paper evaluates the impact of these rapid credit expansions on the Sustainability of fiscal policy in South Korea and Thailand. In Thailand, a rapid credit expansion preceded the currency collapse that heralded the Asian crisis. Fiscal policy in South Korea appears to be consistent with its long-run budget constraint, while fiscal policy in Thailand is not consistent with its long-run budget constraint. A loss in international confidence may considerably tighten their borrowing limit very rapidly, regardless of the long-run Sustainability of fiscal policy.  {This is the same conclusion that Alan Greenspan has repeatedly made about the economic policies of the US Republican Party based upon a similar credit expansion in the US economy.  Read or watch for example his hearing before Congress 4/20/05.—JK}

For an article directly on the credit expansion and the size of the us debt by Federal Reserve Bank of San Francisco

1. Introduction

In the decades before the 1997-1998 Asian financial crisis, South Korea and Thailand experienced sustained economic growth attributable to investment growth and productivity gains. The investment underlying this economic expansion was financed by relatively high levels of private savings as well as by foreign borrowing. During the crisis, interna­tional creditors lost confidence in these countries, prompt­ing higher costs of borrowing, and leading to a wave of bankruptcies by many seemingly sound firms. This further undermined international investor confidence and led to a rapid outflow of short-term capital and a sharp depreciation of domestic currencies, a phenomenon termed a sudden stop by Calvo (1998) and (Calvo and Reinhart 1999). The ensuing crisis led to the collapse of the financial sector and of economic activity.


The rapid expansion of foreign credit is seen by many as the primary cause of the Asian financial crisis. Calvo has argued in many papers that traditional theories of emerging market crises that identify poor fiscal performance as the direct cause of instability are not sufficient to explain the sudden stop episodes. Instead, he argues that weaknesses in the financial sector, particularly those due to a large por­tion of foreign exchange-denominated liabilities in the domestic financial sector, make emerging markets particu­larly prone to crises.

In line with Calvo's arguments, South Korea and Thailand had relatively sustainable fiscal policies prior to the Asian crisis.1 However, the long-term bailout cost of their financial sectors amounted to an estimated 30 to 40 percent of output in both countries. This was financed largely by public borrowing. This large increase in public debt deteriorated the countries' fiscal accounts. Govern­ments in both countries were forced to increase taxes and cut social spending to free resources to repay the debt. The global economic slowdown of 2000-2002 re­strained export growth and limited the amount of foreign funds available to South Korea and Thailand. Moreover, to limit further vulnerability to capital flow reversals, these countries were reluctant to rely on additional foreign funds and thus instituted capital controls and began paying off foreign loans. With foreign financing precluded, both countries sought to stimulate their economies by expand­ing domestic demand. However, the governments were re­strained from boosting domestic demand through expansionary fiscal policy because policies recommended by the International Monetary Fund (IMF) encouraged greater fiscal austerity. Consequently, South Korean and Thai policymakers encouraged domestic demand by in­creasing public credit and encouraging commercial banks to increase credit to private firms and domestic consumers. Led by private consumption, both economies expanded. In South Korea, output grew by over 6 percent in 2002, and consumption grew by 6.7 percent. In Thailand, output grew by 5.4 percent in 2002 and by 6.7 percent in 2003, and con­sumption grew by 4.9 percent and 6.2 percent, respectively.


The recent credit expansions in South Korea and Thailand create new contingent liabilities for the govern­ments of each of these countries as the probability of a banking crisis (and its size) increases if private credit grows very rapidly above trend. Indeed, one factor that can weaken a financial sector and often leads to a sudden stop episode is a rapid expansion of credit to the private sector. Examining historical evidence on the cost of deflating credit expansions in emerging markets, a study by the IMF (2004) finds that if private credit expands too rapidly above a historical trend, termed a credit boom, the expansion usu­ally deflates under its own weight, just as stock market bubbles eventually burst. The IMF study finds that private credit booms in emerging markets are associated with con­sumption and investment booms (with a 70 percent proba­bility), followed by banking crises (75 percent) and currency crises (85 percent).


Credit expansions create contingent liabilities that are not directly measured by the government's debt position. These contingent liabilities include both explicit liabilities, created by bank insurance funds and government owner­ship of government banks, and implied liabilities created by possible bailouts of the financial system. The IMF esti­mates that, for 60 emerging market banking crises, the av­erage added debt was 14 percent of GDP (IMF 2003). For South Korea and Thailand, the increase in public debt alone was in the order of 20 to 30 percent of GDP (He 2004).


The goal of this paper is to evaluate the sustainability of fiscal policy in South Korea and Thailand in the presence of contingent liabilities created by rapid credit expansion. First, I identify periods of rapid credit expansion in South Korea and Thailand using a methodology proposed by the IMF (2004). I show that both South Korea and Thailand have experienced rapid credit expansions in recent years. For Thailand, a rapid expansion preceded its currency col­lapse, which heralded the Asian crisis. The analysis shows that South Korea and Thailand have experienced periods of rapid credit growth that put them at risk of financial instability, which may in turn prove a threat to fiscal sustainability.

Second, I analyze the long-run sustainability of fiscal policy using an empirical test suggested by Bohn (1998). The test addresses the question of whether governments re­spond to larger public debt by increasing their primary sur­pluses. If governments respond in such a way, they can be shown, under mild conditions, to -satisfy their long-run budget constraint. I find that fiscal policy in South Korea

has been consistent with its long-run budget constraint. But in Thailand, especially for the 1990s, fiscal policy has not been consistent with its long-run budget constraint. Further, I ask whether, in the face of increasing contingent liabilities from recent credit booms, the governments of South Korea and Thailand are taking corrective actions. In particular, I augment the Bohn regressions by including variables to measure private credit expansion. The increase of credit to the private sector represents a contingent liabil­ity to the government. I find that, while South Korea has not been provisioning for increased contingent liabilities by increasing its fiscal surplus, Thailand has run larger deficits as private credit has grown.


Finally, I analyze the sustainability of fiscal policy by presenting the results of stress tests on the level of public debt. In particular, I estimate a debt limit proposed by Mendoza and Oviedo (2004) for South Korea and Thai­land. Then, I ask how close these economies come to their debt limit if they are forced to increase public debt to bail out the financial system again. I also estimate how much tighter their borrowing limit would become if international investors lost confidence in those economies and de­manded higher interest rates for lending funds to the gov­ernment. The results for both countries show that a loss of confidence in their economies may tighten their borrowing limit considerably.


The rest of the paper is organized as follows. Section 2 presents the methodology that will be used to assess the sustainability of fiscal policy in South Korea and Thailand in the face of rapid credit expansions. Section 3 briefly de­scribes some salient features of the data used in the paper. Section 4 presents the results of the analysis. Section 5 concludes.


{The body of the paper (10 pages) is complex mathematical analysis and table for which one would at least have to be a 3rd year economics student for to comprehend.  I believe that visitor to this website have neither the background or the motivation to read the body of this paper.—jk} 


Thailand’s average output growth rate between 1972 and 2001 was about 4.6 percent.  For simplicity, assume that Thailand faced the same average real interest rate as South Korea (6 percent).  The NDL is set at Thailand’s maximum level of public debt between 1972 and 2001, 35.4 percent.  Given NDL, I find that the government expenditure-to-output ratio is approximately 2.5 times the standard deviation below mean government expenditures.


As of 2001, the debt-to output ratio for Thailand was about 29.8 percent.  Thus, Thailand also appears to be close to its NDL.  However, if the rate were to increase to 7 percent, the resulting NDL would be about 20.5 percent.  Thus, a long-term increase in the interest rate would push Thailand much closer to its NDL.  One caveat is in order for Thailand’s results:  the NDL depends on the assumption that its government would be able to reduce expenditures to about 10.5 percent of GDP.  Thailand’s minimum level of expenditures over the sample period are 12.5 percent of GDP, so the implied fiscal adjustment that supports it NDL could be very hard to achieve.  A second caveat involves the sensitivity of the NDL to small changes in the interest rate and the growth rate. Finally, even though Thailand has had a worse fiscal policy and larger public debt levels compared with South Korea, its NDL may still be closer to the mean for other developing economies. The calculations show how changes in economic conditions may sharply reduce the borrowing limit for the govern­ments of Thailand and South Korea.


5. Conclusions

Given the results of this paper, it appears that South Korea's fiscal policy has historically been consistent with its long-run balanced budget constraint. Moreover, it ap­pears that the sustainability of fiscal policy has strength­ened in recent years. However, South Korea has not provisioned to cover implied liabilities created by rapid in­creases in real private credit. If those increases were to be­come booms, South Korea might be pushed against its borrowing limits. However, there is little evidence that South Korea is near a credit boom, so the probability of reaching its NDL is low.


Thailand, on the other hand, appears to be running a fiscal policy that is inconsistent with satisfying its long-run balanced budget constraint. Moreover, it appears that the quality of fiscal policy has weakened. Additionally, Thailand has tended to run larger primary deficits in re­sponse to private credit growth. While Thailand seems to be far away from its NDL, a worsening of conditions, such as a long-term increase in the interest rate caused by loss of confidence and subsequent fiscal costs of dealing with a distressed financial sector, may push Thailand above its NDL.


Thailand's current and continuing ability to borrow in­ternationally may call into question the reliability of Bohn's test of fiscal sustainability. For one thing, Bonn's test of sustainability of fiscal policy is a test of the long-run budget constraint. So, creditors may be willing to extend credit temporarily as long as Thailand keeps current with its international obligations. Additionally, there may be an expectation on the part of agents that fiscal policy may strengthen in the future. However, the NDL results suggest that sudden changes in lenders' economic perceptions that may be reflected in increases in interest rates can quickly reduce the amount of borrowing Thailand may be able to tap. This is particularly worrying if this coincides with a drop in the rate of output growth, which would be the time that Thailand would need to access capital markets the most.


Two factors will help the governments of South Korea and Thailand avoid a crisis or limit its effects should one occur. First, the current expansions in South Korea and Thailand are mostly financed by domestic residents in the form of domestic currency-denominated debt. Thus, these countries are not as vulnerable to a rapid depreciation of the exchange rate that would inflate the real cost of making debt payments, as in a sudden stop episode. Second, the currencies of Thailand and South Korea have tended to ap­preciate against the dollar and their current accounts have recorded large surpluses. Thus, South Korea and Thailand have accumulated substantial stocks of foreign assets to pay off debts and recapitalize their banks in the event of a crisis.


1. For the purposes of this paper, a policy is sustainable if it is consistent with the long-run government budget constraint if maintained indefinitely





The Bush deficit has not yet reached Reaganesque proportions (it stands at roughly 4.5 per cent of GDP). But Professor Pollin, for one, predicts that the resulting debt burden could rapidly rise to the levels seen in the 1980s, with interest repayments eating up as much as 18-19 per cent of the overall federal budget. Thus billions of dollars are spent on interest payment, rather than in publicly useful programs such as universal medical insurance, like those in the other developed countries of the world.

There is an inherent instability in the capitalist system.  Almost every year there is a crash with a government defaulting on its payments.  In the last decade, Mexico, Argentina (Nov. 02, $805M), Russia, Ivory Coast (June 04 on $700M), and several Asian nations.   What follows are predictions for 05, followed by 5 economic wild-cards that could bring on a recession or worse.


Predictions for 05, a survey of 60 forecasters in Business Week Magazine.:


What they predict:

1.  GDP growth of 3.5%

2.  Profits grow by 6.7%

3.  Oil to slip to $39/barrel by year’s end

4.    Fed Reserve to raise fed fund  rates from 2.25% to 3.5%

5.   10-yearTreasury bonds will increase form 4.3% to 5.1%

6.  Dollar lose about 10% value against major currencies


Economic Downturn 05, Likely Causes



Their list:

A.  Dollar collapse: growing concern for US ability to attract foreign capital to finance both private and public investments.  The effect of high budget deficit subtracts from domestic savings (and thus investing) and the huge trade deficit also adds to financing needs.  This dependence on foreign financing reducing confidence in the US economy (in 85-87 the dollar fell 49% against major currencies, Treasury bonds increased 2%, and stock prices fell 30%.   A falling dollar would especially effect US corporate bonds (held 50% by foreign investors).

B.  Oil rise would slow consumer demand, and this would under mine business and consumer confidence. 

C.  Inflation, both rising oil and falling dollar make consumer goods more expensive (inflation). China would thus revaluate their currency higher, thus increasing inflation.  High inflation makes existing bonds unattractive and new one must be offered at a higher rate.

D.  Housing bubble:  higher interest rates of 2% could bust the housing bubble, and deflating price deflates household wealth, and so on. 

E.  Global economy:  Euro is weighed down by currency appreciation, and both Euro and Japan are experiencing a slow down of economic growth, and increasing Arab violence would erode business and consumer confidence. 

For the best account of the Federal Reserve  (  One cannot understand U.S. politics, U.S. foreign policy, or the world-wide economic crisis unless one understands the role of the Federal Reserve Bank and its role in the financialization phenomena.  The same sort of national-banking relationships as in our country also exists in Japan and most of Europe.