Asian Financial Crisis of 1997 the Economies

Asian Financial Crisis of 1997

The economies of the so-called "Asian Tigers" were looked at with envy by the rest of the world in the early 1990s. These Southeast Asian countries -- South Korea, Taiwan, Singapore, Hong Kong, Malaysia, and Thailand had shown impressive (in most cases double-digit) growth rates for the preceding decade and more; thus becoming "darlings" of liberal capitalism and globalization in the post-cold war era. Other developing countries were looking to follow their example, and indeed Indonesia and Philippines were straining at the leash to join the "tiger" club. Investors, bankers, and fund managers from all over the world were queuing up to be part of the Asian "economic miracle" -- and perhaps make a quick buck or two in the process. What's more -- the "trickle down effect" was actually pulling the poverty line in the region steadily downwards giving rise to a growing and vibrant middle class. The financial world had, apparently, learnt its lessons from the Mexico crisis of just a few years ago and very few economists saw any cloud on the financial horizon of East Asia until a financial "storm" hit the region in the summer of 1997, seemingly without warning.

This paper is about the Asian Financial Crisis of 1997, which struck Thailand in July 1997, soon engulfed most of the countries in the region and at one time threatened to spread the world over. It describes how the crisis developed, gives a hypotheses about its causes followed by evidence from research, explaining the causes in detail. Effects of the crisis and a conclusion containing a summary of the research and lessons learnt are also included.

The Brewing Crisis

The first faint indications that all was not perfect in the model economies of South East Asia appeared in January 1997, when Hanbo Steel (a large Korean chaebol) collapsed under 6 billion dollars debt. This was the first bankruptcy of a leading Korean conglomerate in a decade. On March 10, 1997 the Thai government failed to follow through on its commitment to $3.9 billion in bad property debt from financial institutions. The international financial institutions were still not alarmed as, on hearing the news, the IMF Managing Director Michel Camdessus remarked: "I don't see any reason for this crisis to develop further."

After another Korean conglomerate (Sammi Steel) went under in the same month, the Japanese government threatened to raise interest rates to counter the decline of the yen. Although the Japanese did not eventually follow-up on their threat, this sent a danger signal to Global investors who began to sell Southeast Asian currencies and stock.

The Meltdown Starts

The following is a blow-by-blow account of the main events that occurred during the Asian 'meltdown' of 1997:

Thailand's Currency Hit by Speculators (May 14, 1997)

Thailand was the first country affected by the Asian financial and currency crisis of 1997. The crisis started on May 14, 1997 when speculators hit the Thai currency (baht) massively -- it was the first breach in the dam, which opened the floodgates of one of the most serious financial meltdowns in recent memory. Initially the governments of Thailand and Singapore moved jointly to support the baht, but it proved to be a futile effort.

The Thai finance minister who was against devaluing the country's currency resigned on June 19. The Thai Prime Minister continued to declare that that his country would 'never devalue the baht' as late as June 30. But things had already gone out of hand as the Thailand's central bank had limited reserves of dollars and soon ran out of them in trying to defend the baht. The Bank of Thailand was forced to announce a managed float of the currency on July 2 with an SOS to IMF for help. This resulted in a sudden devaluation of baht to record lows against the dollar. The start of the currency crisis in East Asia was now well and truly underway.

The Contagion Spreads (July, 1997)

The Philippines was the next country to feel the pressure of the currency crisis and peso was devalued on July 11 with the IMF called in for support that agreed on a $1.1 billion rescue package in the next few days.

By July 24, the currency crisis had engulfed the entire Southeast Asia as the Thai baht, the Malaysian ringgit, the Philippine peso, and the Indonesian rupiah all come under renewed pressure.

Indonesia Feels the Heat (August~ October, 1997)

As currency speculators flexed their muscles, Indonesia was forced to abandon its fixed exchange rate against the dollar on August 14, 1997 and the rupiah plunged dramatically on the currency markets. By October 8, the situation had become desperate for the country with rioting on the streets and it was forced to ask for IMF's assistance to stabilize its currency. It eventually agreed to provide a $40 billion package but with stiff conditions.

Stock Market Panics (October, 1997)

The Hong Kong stock market panicked and lost one quarter of its value in just four days between October 20 and 23 over fears that the Hong Kong dollar would be unable to maintain its fixed peg to the dollar.

On October 27, the panic spread to Western Stock Markets as the Dow Jones Industrial Average on the New York Stock Exchange plunged 554 points -- its largest one-day fall in history on fears that the Asian Financial Crisis could hit U.S. companies.

Korea Affected (November~ December, 1997)

Unable to defend the unbearable pressure on its currency, South Korea eventually abandoned the defense of the won on November 17 that quickly plunged to 1000 to a dollar. Korea also calls for an IMF bail-out which approved a $21 billion loan in December -- part of a $60 billion package -- the largest ever approved by the IMF.

The Meltdown Continues (January~February, 1998)

The start of the New Year saw no let up in the continuing fall-outs of the Asian crisis. On January 12, 1998 Peregrine -- Hong Kong's largest independent investment bank went under -- the result of massive bad debts to failed Indonesian companies, most having links to President Suharto and his relatives. The Hong Kong and Chinese stock markets fell in unison over the news. The Indonesian currency reached an all-time low (17,000 rupiah to the dollar) against the dollar on January 22 over widespread skepticism about the commitment of the government to reform, before intervention from the central bank to support the currency.

Japan Opens Up its Financial Markets -- the Yen Slides (April, 1998)

When Japan announced the liberalization and opening of its financial markets in April 1998, the yen began to slide immediately. It fell to an eight-year low mark by June when the United States had to intervene to support the currency. First signs of troubles in the Japanese economy began to appear when the Long-Term Credit Bank of Japan, was merged with Sumitomo Trust Bank, to stave off a collapse in July 1998.

Indonesia: Suharto Resigns (May 21, 1998)

President Suharto resigned after prolonged violent riots throughout the country -- the biggest political casualty of the crisis. President Habibe took over with promises of economic and political reforms but Indonesia's troubles seemed far from over.

Hypotheses

Several different hypotheses have been advanced as the basic reason behind the Asian financial crisis of 1997/98 -- ranging from Mahathir's finger pointing at the 'immoral' foreign investors such as George Soros to blaming 'Confucianism' and 'crony capitalism' by other analysts. There may be some truth in all these theories but in my view the very success and the region's rapid and uncontrolled economic growth of the preceding decade may well have been the main reason for the financial and currency crisis.

The unprecedented economic growth of the Southeast Asian countries' in the 1980s and 90s was a result of 'opening-up' of their economies to take advantage of the globalization trend. This coincided with rapid appreciation of the Japanese yen in the mid-1980s that drove the cost of production sky high in Japan, forcing several Japanese companies to move their production facilities offshore -- initially, to South Korea and Taiwan. The Japanese also started an aggressive policy of monetary expansion resulting in 'asset price bubble,' and triggering massive capital inflows into South Korea and Taiwan. By the late 1980s, the Korean and Taiwanese economies experienced a similar appreciation in their currencies, followed by similar policies and large capital outflows -- to the neighboring Southeast Asian countries.

Taking advantage of lower labor costs these countries quickly developed export-oriented industries. While their economies grew rapidly by integrating into the globalization process, there was not enough understanding of the risks involved in such rapid changes, or they were ignored in the optimism and intoxication of success.

As the financial services sectors were liberalized rapidly, they could not be regulated, nor could adequate systems be developed to absorb the huge inflow of foreign funds. This basic weakness in the financial sector, including weak banking regulations was the primary cause for the Asian financial crisis and proved to be the 'Achilles' heel' of these countries.

Closer Look at The Causes

Financial Sector Weaknesses

In order to attract foreign capital flows the financial services sectors were liberalized rapidly in the Southeast Asian countries such as Thailand and Indonesia. Due to the haste, inexperience and lack of expertise adequate systems for proper regulation of financial institutions were not developed in time. Singapore's former PM Lee Kwan Yew also terms inadequate systems as the primary reason for the Asian crisis when he says: "The primary weakness was inadequate systems to absorb this huge inflow of funds in the last three years, during a period of euphoria about the Asian miracle."

The problem areas were identified as lax lending standards, weak supervisory rules and procedures, inadequate capitalization, excessive inter-connected lending, and a general lack of a credit culture. Safety nets such as deposit insurance were lacking in some countries.

Half-hearted Financial Reforms

Ironically, the countries most severely affected by the crisis were the ones that did attempt financial sector reforms aimed at upgrading financial institutions but did not follow through with sufficient regulatory reforms. For example, in Indonesia deregulation in the banking sector led to an increase in the number of private banks from 74 in 1988 to 206 in 1994. The countries that carried out these half-hearted financial sector reforms (Thailand, Indonesia, and South Korea) attracted a lot of short-term loans and were ultimately affected most by the crisis. On the other hand, countries that had strong regulatory mechanisms in place, e.g., Singapore and Hong Kong were not as badly affected. Countries (China, Vietnam) that had not undertaken any significant financial sector reforms were shielded in the crisis, as they had not attracted many short-term loans in the 1990s.

The moral of the story, therefore, is that half-hearted reforms in the financial sector are worse than no reforms at all!

Private Sector Borrowings

Traditionally in Asia, the governments did most foreign borrowing through the World Bank or consortiums of other international banks. As the Asian economies were liberalized in the 80s, the private sector local banks could borrow directly from foreign commercial banks at low interest rates and re-lend to local companies. In the 90s the proportion of these private sector borrowings increased dramatically.

Short-term Loans

Many banks and businesses in the troubled Asian economies had taken such short-term loans and some economists blame these as the primary reason for the Asian crisis. Short-term debts in Korea, Thailand, and Indonesia stood at $68, 46, and 34 billion respectively at the end of 1996 and their ratio to foreign exchange reserves consistently exceeded one in Thailand, Indonesia, and Korea after 1994. Such a high ratio is indicative of vulnerability to a crisis.

Peg with Dollar: Appreciating Exchange Rates

Most of the countries in the region kept their currencies pegged to the dollar and did not allow for adjustment of the exchange rate with changing economic conditions. This 'stable exchange rate policy' had the advantage of attracting foreign investment and the lowering of exchange rate risk for trade with the United States and countries with similar dollar pegs. However, when the dollar started to appreciate significantly in 1995/96, the 'pegged' currencies deviated sharply from their market values and needed increasing intervention from the government. It also made exports of these countries expensive in countries not pegged to the dollar, particularly Japan. Since the whole philosophy of the 'Asian miracle' was based on strong exports, this was a disastrous situation. It also gave an opportunity to traders and speculators to bet on the eventual fall of these currencies. When such attacks came at the start of the crisis there was a freefall in the values of the currencies far below their equilibrium levels.

Lack of Transparency

Lack of adequate systems and genuine absence of knowledge may have resulted in absence of timely information about the weak areas like non-performing loans. However, some governments also cover up such bad news information deliberately that prevents timely action being taken until a crisis situation develops. When world attention began to be focused on Japan's problem of non-performing bank loans, its government first announced in 1994 that the total amount of such loans was about $136 billion. A year later, it admitted that the total was close to $400 billion or about 9% of gross national product.

Mistakes Made in the Wake of the Crisis

The mistakes made by several countries and agencies after the crisis had started resulted in worsening it. When the property prices in Thailand began to fall in 1996, the Thai government spent a considerable portion of its foreign exchange reserves in maintaining the currency's peg to the dollar and in propping up failed banking institutions instead of arranging for their closure, or merger. For example, the government injected $3-4 billion in the Bangkok Bank of Commerce after its seizure in 1996. The Bank of Thailand spent $19.3 billion to keep 91 finance companies afloat in 1996/97 and spent another $16 billion in defending the baht in late 1996 / early 1997 and another $23 billion in forward trading swaps by June 1997. When the investors realized that Thailand's foreign reserves had fallen below its short-term foreign debts, they panicked and started to withdraw their investments from (not just Thailand) but the entire region. Another inexplicable move was the Korean government's decision to allow some of its Chaebols to fall, and then spending a large part of its reserves in defending its currency.

The unduly harsh comments of the Malaysian Prime Minister, Mahathir's comments about foreign investors and speculators and his threats to ban foreign currency trading did not help matters either.

Many experts believe that the IMF response to the crisis instead of improving the situation, exaggerated the collapse. The initial remedies suggested by the IMF were its standard recipes for commonplace balance-of-payment crises such as focus on fiscal deficits, high interest rates, restrictive money growth and closure of insolvent financial institutions. The inappropriateness of the IMF strategy is reflected in the discarding of the original fund programs within months of their introduction.

Effects of the Asian Financial Crisis

Re-evaluating the Benefits of Globalization

Before the Asian crisis of 1997-98 there was tremendous enthusiasm (verging on euphoria) about the benefits of globalization for the developing world. The reason was the tremendous growth shown by the East Asian countries by opening up their economies and using export as the engine of growth. The crisis and its aftermath has forced the developing world, in particular, to re-evaluate the benefits of globalization and made them realize that it is a double-edged sword bringing risks with opportunities. Now much more prudent policies are called for if the developing economies are to benefit by integrating in the world economy.