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

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