Which Capitalism Lessons from the East Asian Crisis Summary
For this we first have to understand some basic features of these systems. There are two basic goals of a financial system, to allocate resources productively and give return to the financier. The relationship based system accomplishes this task by granting them implicit or explicit power over the firm being financed (Rajan and Zingales, 2000). The financier attempts to secure their investment by getting a monopoly on the firm. For this purpose some barriers are required to increase entry costs for competitors. This is in contrast to the arms length, Anglo-Saxon system where the financier is protected by explicit contracts. In this system the relationship between institutions matter less and the terms of transactions are better directed by the market.
The main and important difference in both of these systems is the degree of reliance on legal enforcement. The relationship based system does not depend much on legal enforcement. Instead, the enforcement is based on parties maintaining their reputation to ensure continuing business in the same network of firms. The arms length Anglo-Saxon system, on the other hand, explicitly depends on the enforcement of laws and the binding nature of contracts. The courts help keep up the spirit of the contracts under common law thus this system is dominant in countries with common law tradition. Another big difference is the transparency of contracts. Market based systems require transparency as a guarantee of protection (Porta and Silanes, 1997) while relationship based systems depend on opacity in order to preserve the relationship from the threat of competition.
For example, in relationship based systems when giving credit the bank will focus not on the risk of the project for which funds are required but rather on the firms long term ability to pay and various non-contractual levers the bank can pull to extract payment. The interest rate will be repeatedly negotiated. In arms length systems on the other hand, the loan will be for a specific time period and it will be a competitive one (Rajan and Zingales, 2000). When Mazda was in trouble, Sumitomo Bank did not only guarantee its debts but also ensured its rescue by taking other measures such as encouraging its employees to buy Mazda cars. This is because they had a relationship with Mazda which they expected to be continued after Mazda was back on track. Since relationship based systems are based on fostering relationships, there really is no price guidance.
Not everything about relationship based systems is, however, bad. They can sometimes allocate funds much more effectively than the arms length system because of their reliance on relationships. They allow companies to be more steadfast and stick to their objective because these companies know the banks have their back and thus they can take more risks. However the big downside is that this means that companies in the relationship based system are not very reactive to changes in price and cash flows. This has led to a huge misallocation of resources. Arms length systems (Rajan and Zingales, 2000), on the other hand allocate resources on the basis of market prices which makes them much more effective in fostering productivity.
However one place where the relationship based system seems to be working very well is in conglomerates. Conglomerates are the ultimate relation based systems because they represent a group of businesses working together through an internal capital market (Porta and Silanes, 1997). If the market system was used the funds would be allocated to the firms which were performing well and taken away from the low performance units. However it does not happen this way, instead the conglomerates often take funds earned by the good units and invest them in the weak units in order to make them perform better. It has been observed that conglomerates perform much better in developing economies, this may signal that the relationship based system works better when contractual binding is low and laws are not well enforced. In economies with a sufficient degree of contractual infrastructure the arms length transactions perform much better.
As per (Porta and Silanes, 1997) There are two factors which seem to affect the performance of relationship based systems. These factors are the adequacy of the contractual infrastructure and price signals. The Asian crisis can be seen as happening because of the fact that a lot of foreign investment came to Asia at a time when there was no proper infrastructure (Rajan and Zingales, 2000). As the two systems combined some misunderstanding and problems surfaced. Because the investors were not sure that their funds were being allocated properly and did not have enough safeguards to protect their investment they made sure that their investments were short term so they can pull out at the first sign of trouble. Thus when some fluctuations occurred the foreign investors started pulling out and due to the dependence on relationships everyone was affected by these.
The question that remains is that where do we go from here. In this papers opinion, relationship based system is the best choice to go to in the short run. However when the economies become stable again the Asian economies will have to create a proper infrastructure in order to make sure that proper cash inflows come in from foreign markets. The foreign investors need safeguards on their investment to make sure they can invest in long term. According to (Porta and Silanes, 1997) this will keep something like the Asian crisis for happening again. However in the short term the relationship system will have to work because the local businesses have been working on it and they will have to become stable and re-launch the economy. This has to be done in order to attract any form of foreign investment to these countries which rely on the relationship based system.