This paper examines the 1997–98 Asian financial crisis and its far-reaching effects on the international monetary system (IMS). Beginning with an overview of the IMS — from the gold standard and Bretton Woods to the rise of the IMF — the paper traces how currency depreciations in Thailand, Indonesia, South Korea, and neighboring economies set off a chain reaction of capital flight, equity collapse, and debt crises that spread to Russia, Latin America, sub-Saharan Africa, and Eastern Europe. The paper also analyzes the role of the euro as an emerging reserve currency, the debate over dollarization in Latin America, and the structural vulnerabilities in the IMS exposed by the crisis. It concludes with proposals for reforming international financial institutions and governance frameworks to prevent future systemic crises.
The international monetary system (IMS) is a structure of rules and principles that manages international finance. It carries major distributive consequences for the authority and well-being of states in the international system. The IMS does not maintain a neutral status, either economically or politically, and deals with three core technical issues: the liquidity of money supply to fund business and monetary assets; the fine-tuning of appropriate short-term imbalances; and the restoration of trust in national currencies to avert damaging swings in exchange rates.
The gold standard was the foremost modern global monetary system. In force during the late nineteenth and early twentieth centuries, it provided for the free movement of gold coins of standard specification among countries. Within the system, gold was the sole standard of value. In the decades after World War II, international trade was conducted according to the gold standard's logic, but in a modified form: countries determined the value of their currencies not directly in relation to gold, but in relation to a foreign currency — the U.S. dollar — that was itself linked to and exchangeable for gold. Most countries fixed their currencies to the dollar and maintained dollar reserves in the United States, which became known as the "key currency nation."
The United Nations Monetary and Financial Conference held July 1–22, 1944, at Bretton Woods, New Hampshire — commonly called the Bretton Woods System — gave birth to the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (now the World Bank). By December 1945, the requisite number of governments had ratified the agreement, and both organizations began functioning by the summer of 1946. Bretton Woods established a system of managed exchange rates designed to enable unhindered flows of trade and commerce.
During the 1960s, U.S. overseas commitments drew down the country's gold reserves, undermining confidence in the dollar. Some countries holding dollar reserves, along with currency speculators, began seeking to exchange their dollars for gold. U.S. gold reserves fell sharply, and as a remedy, the so-called two-tier structure was introduced in 1968. The eventual abandonment of the Bretton Woods and gold standards signaled that currency values would henceforth be determined by market forces.
During the later decades of the twentieth century, Japan's yen and Germany's Deutschmark grew progressively more important in global financial markets, while the U.S. dollar — still the dominant national currency — weakened relative to them. The euro was launched in financial markets in 1999 as a replacement for the currencies of eleven European Union member nations and entered physical circulation in 2002 in twelve EU countries. It soon became the second most widely used currency in the primary bond market, after the dollar.
The IMF serves as the pivotal body of the international monetary system, using a fund pledged by member countries to lend foreign currencies to members in need, in order to settle international obligations and stabilize exchange rates. Its stated objective is to prevent systemic disaster by encouraging nations to adopt sound economic policies and to provide short-term funding to members facing balance-of-payments difficulties. Nevertheless, the IMF was widely criticized during 1998 for worsening the Asian financial crisis by requiring Asian economies to raise interest rates to historically unprecedented levels.
The Asian financial crisis, which spread from Thailand to other nations in the region during the second half of 1997, pushed affected countries into deep recession, causing mounting unemployment, poverty, and social displacement. The outbreak challenged certain fundamental assumptions: the nations most severely affected were "tiger economies" that possessed few of the weaknesses normally associated with countries that seek IMF assistance. These countries had ample monetary reserves, high rates of private savings, and low inflation — and in most cases their exchange rates had appeared to be on track.
The Asian crisis was not easy to forecast compared to the Mexican, Russian, or Brazilian crises, partly because these economies had been regarded as models of sound and sustained economic policy, and because of the prevailing confidence in the infallibility of markets and the unqualified benefits of free capital movements. There were, however, some early warnings. The Bank for International Settlements (BIS) Report of 1996 cautioned about exposure in East Asia. The 1996 Trade and Development Report similarly warned about South-East Asia, noting that growth in the region depended heavily on foreign resources and that these economies were losing competitiveness and were highly vulnerable to sudden reversals of capital inflows.
As in other regional crises, the East Asian crisis erupted suddenly — triggered by a loss of confidence and a massive withdrawal of capital by both domestic and foreign investors as well as unhedged debtors. Both external and internal factors, including domestic policy choices, appear to have played vital roles. Four fundamental issues were embedded in the crisis: a shortage of foreign exchange in Thailand, Indonesia, South Korea, and other Asian nations that caused sharp falls in the value of currencies and equities; inappropriate development of financial sectors and capital-allocation systems in affected economies; the impact of the crisis on the United States and the world economy; and questions about the responsibility, functioning, and resourcing of the IMF.
The disaster was triggered by a two-phase currency depreciation beginning in the early summer of 1997. The first phase was marked by steep crashes in the Thai baht, Malaysian ringgit, Philippine peso, and Indonesian rupiah. Once these currencies stabilized at lower values, a second phase began in which downward pressure struck the Taiwan dollar, South Korean won, Brazilian real, Singaporean dollar, and Hong Kong dollar.
As a step toward offsetting the downward pressure on currencies, governments sold dollars from their foreign exchange reserves, bought back their own currencies, and raised interest rates to deter speculators and attract foreign capital. The elevated interest rates, in turn, slowed economic growth and made interest-bearing securities more attractive relative to equities. Share prices plummeted. By November 1997, this weakening of equity values had spread to stock markets elsewhere in the world, even though U.S. and European markets subsequently recovered.
The crisis in East Asian economies was set off by a rapid reversal of short-term capital inflows. Initially, the affected nations attempted to offset the reversal by intervening in currency markets. Their capital stocks were quickly exhausted, however, and their resistance ended. What followed was a rapid collapse in currency values — of a magnitude exceeding the adjustment then considered necessary — compounded by an acute shortage of foreign exchange liquidity. As a direct consequence, interest payments on external debts shot up sharply and defaults became widespread.
Industries were unable to finance imports of required raw materials and components; exporters could not secure letters of credit. In short, large portions of the affected economies suffered severe damage, leaving permanent wounds on the balance sheets of banks and businesses in the countries concerned. A second critical lesson of the crisis concerns exchange rate stability. It became widely recognized that the de facto pegging of regional currencies to the dollar had contributed substantially to the East Asian financial crisis. The affected nations had failed to notice the fundamental instability building in their economies and had not adjusted their exchange rates accordingly.
In that sense, the rigidity of exchange rate policies bore some blame. Yet more important was the fact that the dollar itself had oscillated severely against the yen — another key currency for trade among the affected nations. The dollar's decline during the decade from 1985 to 1995 had generated a substantial trade surplus for the affected nations. When a sharp reversal began in 1995, it wiped out their competitive price advantage and damaged their current account positions, which in turn eroded market confidence and created conditions favorable to crisis. The underlying cause, therefore, was not the dollar-peg system per se, but rather the failure to recognize fundamental economic imbalances and the uncontrolled volatility of the dollar-yen exchange rate. The crisis was also the product of the enormous volume of unstable capital and the herd behavior of market participants, readily triggered by sudden flows of information.
The international monetary system has functioned under turbulent conditions ever since the Asian financial crisis erupted, and the structure of international finance has been the subject of intense debate ever since. The crisis raised a number of crucial questions for the international system, many of them linked to the need for a new international financial architecture. The unfolding of the crisis underscored the inherent difficulty of halting a disaster once it has begun, given the speed with which short-term capital can move in response to shifting market sentiment. Prevention, rather than crisis management, is the essential remedy.
"Crisis extends to other world regions"
"Euro launch reshapes Asian reserve strategy"
"Proposals for restructuring global finance"
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