Asian Financial Crisis of 1997: Causes, Effects, and Lessons

Introduction

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, 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 the Philippines were straining 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 profit in the process.

What is more, the "trickle-down effect" was actually pulling the poverty line in the region steadily downward, giving rise to a growing and vibrant middle class. The financial world had, apparently, learned its lessons from the Mexico crisis of just a few years earlier, 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 examines 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 worldwide. It describes how the crisis developed, offers hypotheses about its causes supported by research evidence, explains the causes in detail, and addresses the effects of the crisis before drawing conclusions and summarizing lessons learned.

The Brewing Crisis

The first faint indications that all was not perfect in the model economies of Southeast Asia appeared in January 1997, when Hanbo Steel — a large Korean chaebol — collapsed under $6 billion in 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 cover $3.9 billion in bad property debt from financial institutions. The international financial institutions were still not alarmed; on hearing the news, 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 Japan did not ultimately follow through on its threat, this sent a danger signal to global investors, who began to sell Southeast Asian currencies and stocks.

The Meltdown: A Chronological Account

The following is a chronological account of the main events that occurred during the Asian financial meltdown of 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 — the baht — massively. It was the first breach in the dam, opening 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 the effort proved futile.

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

The Philippines was the next country to feel the pressure of the currency crisis. The peso was devalued on July 11, with the IMF called in for support; it agreed on a $1.1 billion rescue package within days. By July 24, the currency crisis had engulfed the entire Southeast Asian region, as the Thai baht, the Malaysian ringgit, the Philippine peso, and the Indonesian rupiah all came under renewed pressure.

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 currency markets. By October 8, the situation had become desperate, with rioting in the streets, and the country was forced to seek IMF assistance to stabilize its currency. The IMF eventually agreed to provide a $40 billion package, subject to stringent conditions.

The Hong Kong stock market panicked and lost one quarter of its value in just four days, between October 20 and 23, amid fears that the Hong Kong dollar would be unable to maintain its fixed peg to the U.S. 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 at that time — on fears that the Asian financial crisis could damage U.S. companies.

Unable to withstand the mounting pressure on its currency, South Korea eventually abandoned the defense of the won on November 17; the currency quickly plunged to 1,000 to the dollar. Korea also called for an IMF bailout, which approved a $21 billion loan in December — part of a $60 billion package — the largest ever approved by the IMF at that time.

The start of the new year brought no respite from the ongoing fallout of the Asian crisis. On January 12, 1998, Peregrine — Hong Kong's largest independent investment bank — collapsed as a result of massive bad debts owed by failed Indonesian companies, most of which had links to President Suharto and his relatives. The Hong Kong and Chinese stock markets fell in unison on the news. The Indonesian currency reached an all-time low of 17,000 rupiah to the dollar on January 22, amid widespread skepticism about the government's commitment to reform, before the central bank intervened to support the currency.

When Japan announced the liberalization and opening of its financial markets in April 1998, the yen began to slide immediately, falling to an eight-year low by June — prompting the United States to intervene in support of the currency. The first signs of serious trouble in the Japanese economy emerged when the Long-Term Credit Bank of Japan was merged with Sumitomo Trust Bank to stave off a collapse in July 1998.

President Suharto resigned after prolonged violent riots throughout the country — the most significant political casualty of the crisis. President Habibie took over with promises of economic and political reform, but Indonesia's troubles appeared far from over.

Hypotheses on the Causes

Several different hypotheses have been advanced as the fundamental reason behind the Asian financial crisis of 1997–98 — ranging from Malaysian Prime Minister Mahathir's accusations against "immoral" foreign investors such as George Soros, to analysts blaming "Confucianism" and "crony capitalism." There may be some truth in all of these theories, but the very success of the region and its rapid and uncontrolled economic growth in the preceding decade may well have been the primary driver of the financial and currency crisis.

The unprecedented economic growth of Southeast Asian countries in the 1980s and 1990s was a result of opening up their economies to take advantage of the globalization trend. This coincided with the rapid appreciation of the Japanese yen in the mid-1980s, which drove production costs sky-high in Japan, forcing several Japanese companies to relocate their production facilities offshore — initially to South Korea and Taiwan. Japan also began an aggressive policy of monetary expansion, resulting in an "asset price bubble" and triggering massive capital inflows into South Korea and Taiwan. By the late 1980s, the Korean and Taiwanese economies experienced similar currency appreciation, followed by similar policies and large capital outflows to 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 insufficient understanding of the risks involved in such rapid change — or those risks were ignored in the optimism and intoxication of success.

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

Conclusion

The Asian financial crisis of 1997–98 was one of the severest financial meltdowns to hit a group of countries in recent history, and at its peak threatened to engulf much of the world. It was the first "computer-age" crisis, demonstrating the true impact of globalization and the ease with which massive funds could be relocated from markets — literally at the touch of a button. The crisis was also unique in several respects. It came as a complete surprise to most observers and financial experts, partly because most of the affected countries had been exhibiting strong economic fundamentals until the very end. Unlike most previous financial crises of similar magnitude, this one was precipitated primarily by the private sector rather than the public sector.

Attributing the crisis to the "immorality" of speculators, or to cultural factors such as "Confucianism" and "crony capitalism," as suggested by some analysts, is only partially valid. The main underlying cause was the rapid and inadequately regulated growth of Southeast Asian economies in the absence of robust institutions and regulatory frameworks. A huge volume of short-term private-sector borrowing and the pegging of currencies to the dollar were other important contributing factors.

The lessons to be learned are evident in the causes of the crisis. Better regulation of private-sector business practices must now be a priority in most economies. Short-term external debt and the ratio of short-term debt to foreign exchange reserves must be taken seriously when assessing economic vulnerability. The overly optimistic myth of unlimited benefits from globalization has been discredited. It is now generally recognized that integration of developing countries into the world economy also exposes them to considerable risks and volatility. The pegging of currencies to the dollar — or to baskets of international currencies — proved fatal for several East Asian economies and stands as one of the major lessons of the crisis. Finally, the role of the IMF in handling the crisis left much to be desired, as the institution appeared to apply the same prescription to all financial crises regardless of their specific nature.

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