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

Diego Valderrama

Economist 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.