Causes and policy responses, The

Asian financial crisis of 1997: Causes and policy responses, The

Kim, Suk H

For years, East-Asian countries were held up as economic Icons. Their typical blend of high savings and Investment rates, autocratic political systems, export-oriented businesses, restricted domestic markets, government capital allocation, and controlled financial systems were hailed as the Ideal recipe for strong economic growth of developing counties (Shapiro, 1999). However, in July 1997, a currency turmoil erupted In Thailand. This currency crisis spread from there to Indonesia and Korea, then to Russia, then to Latin America. Few countries have not been touched by the global forces that this crisis–some accounts the worst since the 1980s debt crisis–have unleashed. Professor Paul Krugman who threw cold water on the popular enthusiasm on the Asian success story even before the crisis said, “I was 90 percent wrong about what was going to happen, but everyone else was 150 percent wrong. They only saw the miracle and one of the risk.”

RECENT INTERNATIONAL FINANCIAL CRISES

The 1997 Asian crisis is the 4th international financial crisis. The first major blow to the international financial system took place in August 1982, when Mexico announced that it could not meet its regularly scheduled payments to international creditors. Shortly thereafter, Brazil and Argentina were in the same situation. By Spring 1983, about 25 developing countries could not make regularly scheduled payments and negotiated rescheduling with creditor banks. These countries accounted for two-thirds of the total debt owed by non-oil developing countries to private banks at the time.

The second crisis occurred in the fall of 1992, when a wave of speculative attacks hit the European Monetary System (EMS). Before the end of the year, five countries–Finland, the United Kingdom, Italy, Sweden, and Norway had floated their currencies. Despite attempts by a number of other countries to remain in the EMS by devaluing their currencies (Spain, Portugal, and Ireland), the old system was ultimately unsalvageable. The bands of the EMS were widened from +/- 2.25 percent to +/- 115 percent in August 1993. The third crisis came on December 20,1994 when the Mexican government announced its decision to devalue the peso against the dollar by 14 percent. This decision, however, touched off a panic situation to sell pesos, thereby compelling the Mexican government to float the peso. A rash of speculative attacks against other Latin American currencies–Argentina (peso), Brazil (real), Peru (new sol), and Venezuela (bolivar)–broke out immediately through what became known as the tequila effect. Several non-Latin American countriesThailand, Hong Kong, the Philippines, and Hungarysuffered brief speculative attacks. However, only few countries actually devalued their currencies. Argentina was the only other country that suffered a sharp recession as a result of the Mexican peso crisis.

The Asian crisis of 1997, despite prompt and concerted action by developing countries, industrialized countries, and international organizations to contain it, quickly and ferociously spread to north Asian, Latin, and eastern European economies to varying degrees. In fact, this Asian crisis had pushed one-third of the globe into recession during 1998. The crisis has raised a variety of questions not only about the future of the region’s economy, but also about the impact of the crisis on multinational companies and the world economy.

All four crisis episodes occurred under fixed exchange rate regimes. Economic theory suggests that a pegged exchange rate regime can become vulnerable when cross-border capital flows are highly mobile. A central bank that pegs its exchange rate to a hard currency implicitly guarantees that any investors can exchange their local currency assets for that hard currency at the prevailing exchange rate. If investors suspect that the government will not or cannot maintain the peg, they may flee the currency; this capital flight, in turn, delete hard currency reserves and force the devaluation they fear.

Financial crises have taken three main forms: currency crises and banking crises, or both (Kaminsky and Reinhard 1997) Currency crises are usually attacks on the domestic currency that end with a large fall in its value. Banking crises refer to bank runs or other events that lead to closure, merger, takeover, or large-scale assistance by the government to financial institutions. Some times, both banking and currency crises occur around the same time–the so-called twin crises. The 1997 Asian crisis is the most recent example of twin crises. Five East-Asian countries–Indonesia, Korea, Malaysia, Philippines, and Thailand experienced currency turbulence along with serious banking sector problems. Earlier examples of twin crises include Argentina (1981), Uruguay (1982), and Chile (1982). More recently, Mexico (1994), Argentina (1995), Brazil (1998), and Russia (1998) experienced similar problems.

The rest of paper is organized as follows. The first section discusses how an economic crisis in an emerging economy such as Thailand could spread throughout the world. The second section describes how and how much capital flows went in and out of East Asia. The third section analyzes the causes of the Asian crisis. The last section lists policy responses to this crisis.

AN ECONOMIC CRISIS IN THAILAND SPREAD THROUGHOUT THE WORLD

International capital flows caused “booms and busts” for Thailand’s economy. How could an economic crisis in an emerging economy such as Thailand could spread throughout the world. Thailand’s economy surged until early 1997 partly because the Thais found they could borrow money at low interest rates overseas, in dollars, more cheaply than they could at home, in baht. By late 1996, foreign investors began to move their money out of Thailand because they worried about Thais’ ability to repay. In February 1997, foreign investors and Thai companies rushed to convert their baht to dollars. The Thai central bank responded by buying baht with its dollar reserves and raising interest rates.

The rise in interest rates drove down prices for stocks and land. This dynamic situation drew attention to serious problems in the Thai economy: the huge foreign debt, trade deficits, and a banking system weakened by a heavy burden of unpaid loans. The Thai central bank ran out of dollars to support the baht. On July 2, the central bank stopped to defend the baht’s fixed value against the dollar. And then the currency lost 16 percent of its value in one day.

Investors and companies in the Philippine, Malaysia, Indonesia, and Korea realized that these economies shared all of Thailand’s problems. So, investors and companies rushed to convert local currencies into dollars. And then, the peso, ringgit, Rupiah, and won toppled in value like dominos in a row. In the fourth quarter of 1997, the International Monetary Fund (IMF) arranged emergency rescue packages of $18 billion for Thailand, $43 billion for Indonesia, and $58 billion for Korea.

By the end of 1998, the Asian crisis of 1997 spread to Russia, Brazil, and many other countries. Again, the IF arranged bail out packages of $23 billion for Russia in July 1998 and $42 for Brazil in November 1998. This means that since mid-summer 1997, IMF-led rescue packages for Asia, Russia, and Brazil racked up a total of some $184 billion to keep world markets safe.

In theory, capital is a boom, enabling developing countries to reduce poverty and raise living standards. But the theory does not always work smoothly. Countries mismanage the inflows. Banks can be ripe with favoritism or incompetence; bad loans are made. Moreover, multinational companies may build too many factories. Speculation may also propel stock prices to unrealistic heights. Last, ample foreign exchange provided by overseas investors may support a spending spree on imports.

If capital inflows slow or reverse, the boom can collapse. This is precisely what happened in Thailand, where the Asian crisis started. The construction of unneeded office buildings was halted; bad loans mushroomed at finance companies and banks; and the stock market dived. Similar problems afflicted other Asian economies, and losses extended to their foreign trading partners and investors beyond Asia.

There are a number of plausible answers to the question of why the dominos toppled in rapid succession, even though in some cases, they were nowhere near each other (Phillips, 1999). Countries are increasingly connected by trade and investment, so a downturn in one hurts exports and investment of another. Countries also compete against one another. When one country devalues its currency, others can feel pressured to do the same in order to keep their exports and inward investment competitive. Commodity prices provide another link among troubled economies. For example, as Asia sank into recession, its businesses and consumers cut their purchases of oil. That, in turn, accelerated the collapse in the price of crude oil and slashed the revenue for oil exporting countries such as Russia. Russia being a minor player in the league of oil exporting countries is a price taker and not a price setter.

INTERNATIONAL CAPITAL FLOWS IN AND OUT OF THE ASIA

The greater integration of emerging market countries with international capital markets has brought problems as well as benefits for recipients. On the one hand, access to foreign funds has helped finance economic development. On the other hand, greater integration has rendered developing countries more vulnerable to the effects of capital flow reversals, whether due to bad policies or speculation. This vulnerability is highlighted by the Asian crisis of 1997 (Aybar and Milman, 1999). As one observer puts it, “Capital flows around the world are like oceanic tides: in deep bays, tidal movements are little noticed, but in shallow bays, the ebb and flows of the global ocean create huge effect.” Paul Volcker, former chairman of the tJ.S. Federal Reserve System, puts it in a different way, “Small and open economies are inherently vulnerable to the volatility of global capital markets.”

As shown in Table 1, for several years before the outbreak of the crisis, the five Asian countries hit hardest by the crisis–Indonesia, Korea, Malaysia, the Philippines, and Thailand–enjoyed an enormous inflow of foreign capital Line 2 of Table 1), mostly from private sources (Line 3). Most of these private flows came as loans from private creditors (Line 7), such as commercial banks and non-bank creditors. In fact, these inflows tripled in just two years from $25.8 billion in 1994 to $83.5 billion. This foreign capital inflow enabled these countries to finance their current account deficits (Line 1), invest overseas (Line 13), and add to their reserves (Line 14). In 1995, for example, $81.5 billion flowed into these five countries from international source; $41 billion financed the current account deficit and $26.5 billion was reinvested in non-equity assets overseas. The remaining $14 billion went into the countries’ international reserves.

In 1995 and 1996, the bulk of these inflows were from private sources. Official inflows (Line 10)– loans and other financing from international organizations such as the World Bank and the IF (Line 11), as well as assistance from other nations ( Line 12) were either negligible and even negative. That is, the countries were paying back international official creditors.

However, the sharp reversal of capital flows to East Asia in the second half of 1997 is clearly evident in the data. External financing to the five countries dropped from $106.6 billion in 1996 to $28.8 billion in 1997–an amount insufficient to cover the countries’ collective current account deficits at the time. Private flows (Line 3) turned from an inflow of $103.2 billion in 1996 to an outflow of $1.1 billion in 1997. This turnaround of $101.7 billion in one year (actually just six months) was equivalent to about 10 percent of the combined GDP of these five countries. Reserves fell by almost $35.2 billion as the countries attempted to defend their currencies and bolster their economies. Official capital flows, meanwhile, jumped significantly to help cover the short-fall and moderate the crisis.

CAUSES OF THE CRISIS: TWO THEORIES

During the second half of 1997, currencies and stock markets plunged across East Asia, while hundreds of banks, builders, and manufacturers went bankrupt. More specifically, currency values and stock prices of these five Asian countries fell from 40 percent to 80 percent a piece from July 1997 to early 1998 (Pettway, 1999). This crisis in Asia caught nearly everyone by surprise because Asia’s fundamentals looked very good. However, investors and policy makers failed to recognize a number of similarities between the period preceding the Asian crisis and the period leading up to the two previous developingcountry crises: the 1980s Latin American debt crisis and the1994-95 Mexican financial crisis. First, capital inflows to five East-Asian countries were extremely heavy prior to the downturns as international investors enjoyed easier access to domestic financial markets. As in the prior two crises, spreads on Asian emerging market debt declined substantially as investors downgraded the risk difference between developed countries’ and Asian emerging market countries’ debt. Second, these countries enjoyed strong ratings from international creditor agencies and widespread investor participation in their markets. In Asia, as in the previous two crises, both of these two factors could be viewed as very positive developments.

However, as in the prior two crises, there were warning signs that all of the confidence in Asia may have been misplaced. Most domestic borrowers, for example, were unhedged against exchange rate risk, making them to increase their foreign debt load significantly when a borrowing country’s exchange rate changes dramatically. Furthermore, Asian financial institutions had borrowed a significant amount of external liquid liabilities that were not backed by liquid assets, making them vulnerable to panics (Moreno, 1998).

The causes of the Asian crisis include governments’ futile attempts to keep their currencies at artificially high levels; government-directed banking systems and lending decisions; crony capitalism; massive overinvestment by corporations funded by excessive borrowing; the lack of transparency that masked the extent of problems they developed; inadequate financial regulation and supervision; labor market “rigidities”, and a pronounced mismatch in the duration of assets and liabilities in both the corporate and banking sectors (E. Han Kim, 1998).

Perhaps the biggest contributor to the Asian financial crisis of 1997 is its gross misallocation of capital and human resources, combined with a flagrant disregard for the bottom line. This misallocation of capital and human resources caused by the lack of corporate governance had resulted in the widespread value destruction by Asian companies, which in turn had led to a lower value for the overall economy and weakened the banking sector. Underlying all of these weaknesses were pervasive moral hazard– “heads I win, tails someone else loses” philosophy. Banks, investors, and business firms assumed that governments and international organizations would bail them out in the event of financial catastrophe. Such a moral hazard had created incentives for risky behavior on the part of developing countries and international investors.

Neely (1999) argues that “although many explanations have been offered as the causes of the Asian crisis, the vast majority of views fall into one of two theories: the fundamentalist view and the panic view.” The fundamentalist view focuses on how borrowing countries’ policies and practices fed the crisis, whereas the panic view focuses on the role lenders played. The following two sections depends heavily upon Neely’s article.

The Fundamentalist View: The fundamentalist view holds that flawed financial systems were at the root of the crisis and its spread. The seeds for the financial crisis were actually shown several years before currency pressures began. Most East-Asian countries had tied their currencies to the dollar. This tie served them well until 1995 because it promoted low inflation, supported currency stability, and boosted exports. However, the appreciation of the dollar against the yen and other major currencies since 1995 caused East Asian countries to lose their competitiveness in export markets. The crash of world trade in 1996 after two years of rapid growth also affected the Asian markets. From April 1995, the US dollar appreciated continuously and significantly. The dollar linked Asian currencies appreciated accordingly and this made their exports uncompetitive leading to large currency account deficits (see Table 1). Thus, the US dollar appreciation in 1995-97 contributed to 1997 financial crisis. This is similar to the situation in the late 1970s and 1980s when increased interest rates contributed significantly to the Latin American debt crisis.

Meanwhile, the maturity mismatch and the currency mismatch –the use of short-term debt for fixed assets and unhedged external debt–made banks and firms vulnerable to sudden swings in international investors’ confidence. Many economists believe that these two types of mismatch were caused by moral hazard because most East-Asian companies and financial institutions operated with implicit or explicit government guarantees.

An increasing portion of foreign capital inflows to the region consisted of liquid portfolio investment (short-term bank loans and security investment) rather than long-term direct investment. Most of these liquid capital flows were directed into longterm, risky investments, such as real estate. Frequently, these same assets were used for collateral and investment, driving the value of existing collateral up, which in turn spurred more lending and increased asset prices. Risk was further heightened by when local banks–in response to low interest rates abroad and fixed exchange rates at home–began to borrow foreign exchange abroad. These local banks converted the foreign exchange to domestic currency and lent the proceeds to their domestic customers in domestic currency, thereby assuming all the exchange rate risk. Dumside, Eichenbaum, and Robelo (1998) provide evidences that the poor quality of bank assets was well known months or even before the devaluation that marked the beginning of the crisis. Their model implies that the Thai devaluation could have been foreseen over two years before the devaluation occurred.

The fundamentalist view holds that such a bubble was about to burst in the face of a shock. By late 1996, asset prices fell, causing nonperforming loans to rise and the value of collateral to fall; domestic lending then declined and asset prices fell yet again. When capital started to flow out of the region, monetary authorities raised interest rates to defend their currency pegs. However, these higher interest rates raised the cost of funds to banks and made it more difficult for borrowers to service their debts. The monetary authorities soon ran out of hard currencies, thereby causing them to abandon the pegs. Because practically none of some $275 billion in foreign loans owed by these five countries was hedged, the currency depreciations led to widespread bankruptcies and slow economic growth.

These two stories–loss of export competitiveness and moral hazard in lending– combine to explain the severity of the Asian crisis. Appreciation of the dollar and depreciation of the yen and yuan slowed down Asian economic growth and hurt corporate profits. These factors turned illconceived and overleveraged investments in property developments and industrial complexes into financial disasters. The crisis was then touched off when local investors began to dump their own currencies for dollars and foreign lenders refused to renew their loans. It was aggravated by politicians in these affected countries who preferred to blame foreigners for their problems rather than seek structural reforms of their economies. Both domestic and foreign investors, already spooked by the crisis, lost yet more confidence in these nations and dumped more of their currencies and stocks, driving them to record lows.

The Panic View. Subscribers to the panic view admit that there were vulnerabilities: increasing current account deficits, falling foreign exchange reserves, fragile financial systems, highly leveraged corporations, and overvaluation of the real exchange rate. But these vulnerabilities were not enough to explain the abruptness and depth of the crisis. They argue that economic fundamentals in Asia were essentially sound.

Developing countries that experienced financial crises in the past, such as the Mexican peso devaluation of 1994 and the Latin American debt crisis of the 1980s, typically shared a number of common macroeconomic imbalances. These imbalances included large budget deficits, large public debt, high inflation caused by the central bank’s effort to finance the budget deficits by printing additional currencies, slow economic growth, low savings rates, and low investment rates. In Asia, in contrast, most of the economies engulfed by the crisis had enjoyed low budget deficits, low public debt, single-digit inflation rates, rapid economic growth, high savings rates, and high investment rates. In other words, the Asian crisis differs from previous developing country crises in that private-sector financial decisions were the main sources of difficulties. Public borrowing played a limited role in the Asian crisis.

The absence of the macroeconomic imbalances typical of past crises led some to argue that the Asian crisis was not caused by problems with the economic fundamentals. Rather, a swift change in expectations was the catalyst for the massive capital outflows that triggered the crisis. The panic view holds that problems in Thailand were turned into the Asian crisis because of international investors’ irrational behavior and the overly harsh fiscal and momentary policies prescribed by the International Monetary Fund ()Mil) as the crisis broke.

Several factors support the premise that the crisis was panic-induced. First, there were no warning signs, such as an increase in interest rates on the region’s debt or downgradings on the region’s debt by debt rating agencies. Second, prior to the crisis, international banks made substantial loans to private firms and banks that did not have any sort of government guarantees or insurance. This fact contradicts the idea that moral hazard was so pervasive so that investors knowingly made bad deals, assuming that they would be bailed out. It is consistent, however, with the notion that international investors panicked in unison and withdrew money from all investments–good or bad.

Third, once the crisis was under way, the affected countries experienced widespread credit crunches. For example, even viable domestic exporters with confirmed sales could not get credit, again suggesting irrationality on the part of lenders. Finally, the trigger for the crisis was not the deflation of asset values, as the fundamentalists argue, but the sudden withdrawal of funds from the region triggered the crisis. Radelet and Sachs (1998) argue that some of the conditions the IMF imposed on these crisis countries for financial assistance added to, rather than alleviated, the panic.

A key feature of the crises since the 1980s has been the existence of contagion or spillover effect. The panic view is consistent with the concept of “contagion”, which is defined as “co-movements of markets not traceable to common co-movements of fundamentals (Wolf, 1997).” In all three crisis episodes of the 1990s, a crisis that began in one country quickly spread beyond its borders. In some cases the next victims were neighbors and trade partners; in others they were countries that shared similar policies or suffered common economic shocks. At times, as in the summer of 1998, changes in investor sentiment and increased aversion to risk contributed to contagion within and across regions.

Three channels may help to explain such contagion effects. A first channel is heard behavior, attributed to imperfect information problems. Institutional fund managers often follow investment trends of other investors to protect themselves from being blamed in the event of losses for not following trends. Another interpretation is that investors may not discriminate among different fundamentals across markets and regard emerging-market investments as an asset class. A second channel is portfolio allocation: any shock that leads to changes in asset returns in one emerging market will contribute to changes in portfolio allocation to all other emerging markets. A third channel is portfolio interdependence. In response to large capital losses in one country, a sell-off of holdings in other markets occurs in an effort to raise cash to meet investor redemptions. These channels suggest why financial markets have recently become more closely integrated and why shocks have been rapidly transmitted in global financial markets.

POLICY RESPONSES

Regardless of the cause of the crisis and its consequent spillover to other countries, all analysts agree that the fallout in Asia and other emerging markets have been severe. Although initially only financial in nature, the crisis has led to significant real economic losses in these formerly fast-growing economies. Just like the previous developing-country crises, lenders, borrowers, and international financial institutions worked together to overcome the crisis. The external payments situation were stabilized through IMF-led aid programs, the rescheduling of short-term foreign debts, and reductions in foreign borrowing through painful reversals of current account deficits. Financial packages are now being geared to encourage the adoption of policies that could prevent crises in selected developing countries. Backed by a recent IMF quota increase of $90 billion, the IMF would make a continent short-term line of credit available before a crisis breaks out, but only if a country adopts certain policies that would limits its vulnerability. This line of credit is expected to be of short-term and charge interest rates above market rates to discourage misuse (Moreno, 1999).

East-Asian countries closed many ailing banks, cleaned up non-performing loans, encouraged surviving banks to merge with other banks, and compelled these banks to meet the capital adequacy ratio set by the Bank for International Settlements. Corporate sector reforms included capital structure improvement through debt reduction, business restructuring to remove excess capacity, the reorientation of conglomerates on core specialists, and the upgrading of corporate governance standards. These countries also implemented market-opening measures to facilitate foreign investment.

These and other policy responses strengthened financial systems, enhanced transparency of policies and economic data, restored economic competitiveness, and modernized legal and regulatory environment for more stringent regulatory oversight and consistent application of accounting standards. The Asian crisis, like the Latin American debt crisis and the Mexican crisis, have had a profound impact not only on the economies of the affected countries, but also on the developing countries. Our analysis in this paper sheds light on the Asian countries’ reversal of economic fortune and suggests action that may help countries to face and weather out the financial storms in the future.

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Suk H. Kim

University of Detroit Mercy

Mahfuzul Haque,

Indiana State University

Copyright College of Business Administration. University of Detroit Mercy Spring 2002

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