How Asia Works: Finance – The Merits of A Short Leash

By Joe Studwell

Deregulating finance for short-term gains may work in developed Western economies, and even then only at times, but premature deregulation has wreaked havoc in many poorer nations. Here Joe Studwell looks to East Asian economic history to argue that what developing economies really need is tight central-government financial control to support industrial and agricultural development.

“Demonstrating that an exchange economy is coherent and stable does not demonstrate that the same is true of an economy with capitalist financial institutions… Indeed, central banking and other financial control devices arose as a response to the embarrassing incoherence of financial markets.” 1

– Hyman P. Minsky, Stabilizing an Unstable Economy

Modern Approaches

Finance policy in North-East Asia recognised the need to support small, high-yield farms in order to maximise aggregate farm output rather than maximising returns on cash invested via larger, “capitalist” farms. And finance policy recognised the need in industry to defer profits until an adequate industrial learning process had taken place. In other words, financial policy frequently accepted low near-term returns on industrial investments in order to build industries capable of producing higher returns in the future.

The alternative would have been for financial institutions to encourage more consumer lending, which tends to produce higher profits and is the focus of financial systems in rich countries. However, herein lies a far from attractive equilibrium for an emerging economy in which banks become very profitable and industry remains technologically backward. This is the situation in most of South-East Asia and Latin America today. The best banking returns in the East Asian region are produced in the region’s most backward countries – the Philippines, Indonesia and Thailand. The case for deregulating, and liberating, finance so that it seeks out the most immediately profitable investments is therefore not strong in the early stages of economic development. Far better to keep the financial system on a short leash for a considerable period of time and make it serve developmental purposes.

This logic, and the precise financial policies it entailed, came naturally to the post-Second World War regimes in Japan, Korea and Taiwan. Each state had recently experienced a loss of control over its financial system with painful consequences. Japan had witnessed pre-war zaibatsu business groups own and manipulate banks to profitable but selfish ends, buying upstream raw material businesses and utility providers that squeezed the profits out of downstream manufacturers and thereby inhibited the country’s overall manufacturing progress. Korea had privatised banks into chaebol groups in the 1950s such that almost all manufacturing development was stymied. And Taiwan’s Kuomintang (KMT) had lost out to the communists in mainland China in part because financial system instability and hyperinflation had wracked the country in the late 1940s. Post-war governments in each of these North-East Asian states therefore resolved that henceforth money would be made to serve the objectives of national development policy.

Policy During Economic Transformation

Infant industry policy required that funds be directed to industrial projects that were less immediately profitable than either other potential manufacturing investments or consumer lending. Banks were therefore kept under close control. International inflows and outflows of capital were also strictly limited so that domestic capital remained under state control and unregulated flows of foreign funds did not disrupt developmental planning. And the returns that citizens could earn on bank deposits and other passive investments were frequently crimped, increasing the surplus left at the financial system’s disposal, which could then be used to pay for development policy and infrastructure. This amounted to a hidden taxation, which was tolerated by people in these societies because they could see the economic transformation taking place all around them. South Koreans, for instance, put up with negative real interest rates on bank deposits because they saw their economy overtake first North Korea, then the South-East Asian states, then even Taiwan in only three decades.

Financial Home Truths

The essential takeaway from East Asian financial history is that all kinds of approaches to both monetary policy and financial system management have been tried, but what finance is acting on has been far more important than the financial arrangements themselves. The financier has not been the decisive element in the economic development puzzle that many economists claim.2 As a developmental actor, he is defined by and responds to the operating environment around him. It falls to governments to shape that environment and to decide what objectives finance will have.

Control is the key. The successful developing state points financial institutions at the necessary agricultural and export-benchmarked infant industry policies. The state also closes out the possibility that finance will look offshore to alternative opportunities, or that flows of foreign funds will disrupt its plans. It does this by imposing capital controls. The financial deregulation urged by parties to the Washington Consensus does not present a viable alternative to this strategy. Deregulation policies do not empower a “natural” tendency for finance to lead a society from poverty to wealth, they simply put short-term profit and the interests of consumers ahead of developmental learning and agricultural and industrial upgrading. There is no case for doing this when a country is poor.

At best, the developmental emphasis of the IMF, the World Bank and the US government on financial sector deregulation in recent decades has been a waste of time. More commonly, the policy advice has had clear negative consequences. In forcing the pace of banking deregulation, capital account liberalisation and stock market development, the Washington Consensus has undermined East Asian countries’ capacity to shape their development and has greatly increased the risk of financial crises. The risk came home to roost for the Philippines in the 1980s, and for the rest of South-East Asia in 1997. A cult of financial deregulation has taken hold globally in recent decades and has caused plenty of problems in the rich world, but it has caused infinitely greater damage to developing economies.

Financial institutions like banks and bond and stock markets require very long periods of nurture, and considerable bureaucratic and institutional development, before they can be efficient components of a market economy. Even then, financial regulation is the most thorny area of governance for the most sophisticated states. However, the challenges of deregulating finance should not constrain poor countries because efficient financial institutions are not a prerequisite for economic development. Indeed, the danger in describing successful finance in Japan, Korea and Taiwan is that it sounds like it was far more efficient than it was. In reality, governments in North-East Asia directed finance at many wasteful, white elephant projects. Korea was particularly notorious for the bribery that surrounded loan decisions. None the less, with sufficient commitment to manufacturing based on export discipline, the bigger reality was that North-East Asian governments financed enough useful projects to move steadily up the industrial learning curve for several decades, leaving plenty of time to refine financial system performance later.

Ultimately, a finance policy based around control has diminishing returns, just as household farming and infant industry planning do. However, financial control that keeps money aligned with agricultural and industrial policies is essential in the formative stages of development.
The easiest way to run developmentally efficient finance continues to be through a banking system, because it is banks that can most easily be pointed by governments at the projects necessary to agricultural and industrial development. Most obviously, banks respond to central bank guidance. They can be controlled via rediscounting loans for exports and for industrial upgrading, with the system policed through requirements for export letters of credit from the ultimate borrowers. The simplicity and bluntness of this mechanism makes it highly effective. Bond markets, and particularly stock markets, are harder for policymakers to control. The main reason is that it is difficult to oversee the way in which funds from bond and stock issues are used. It is, tellingly, the capacity of bank-based systems for enforcing development policies that makes entrepreneurs in developing countries lobby so hard for bond, and especially stock, markets to be expanded. These markets are their means to escape government control. It is the job of governments to resist entrepreneurs’ lobbying until basic developmental objectives have been achieved. Equally, independent central banks are not appropriate to developing countries until considerable economic progress has been made.


Ultimately, a finance policy based around control has diminishing returns, just as household farming and infant industry planning do. However, financial control that keeps money aligned with agricultural and industrial policies is essential in the formative stages of development. Retail savers and borrowers have to be asked to pay the price of what economists call “financial repression” for as long as is necessary to promote basic technological upgrading. The real problem is that we understand so little about how and when nations should optimally move on to more open, deregulated financial systems. There is no doubt that Thailand and Indonesia and, before them, the Philippines were shunted into extremely premature deregulation. Korea, on the other hand, offers an intriguing case study of forced IMF deregulation at a much later stage of industrialisation. At the time of writing, Korea looks to be in good shape and may have positive lessons to impart. However, the biggest lesson of all has long been clear to anyone who has considered history: that economic development is a complex and dynamic process of stages that requires constant and unending adjustment. There are no one-stop solutions to economic progress.

This is an excerpt taken from the chapter “Finance: The Merits of a Short Leash”, from Joe Studwell’s recently published book, How Asia Works (Grove Press, 2013).

About the Author

Joe Studwell is an author, journalist, public speaker and visiting university teacher. He is currently completing a PhD at Cambridge University. Along with How Asia Works (2013), his books include The China Dream (2002, about the 1990s foreign investment gold rush in China), and Asian Godfathers (2007, about developmental failure in south-east Asia).


1. Hyman P. Minsky, Stabilizing an Unstable Economy (New Haven, Ct: Yale University Press, 1986; reissued New York: McGraw Hill, 2008), p. 106.

2. The most famous exposition of this view is perhaps Schumpeter’s. The banker, he wrote, ‘is essentially a phenomenon of development … He makes possible the carrying out of new combinations, authorizes people, in the name of society as it were, to form them. He is the ephor [the senior magistrate in ancient Greece] of the exchange economy.’ Joseph Schumpeter, A Theory of Economic Development, translated by Redvers Opie (Cambridge, MA: Harvard University Press, 1934), p. 74.

The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.