Financial & Economic Crisis
Financial Crisis of 1997 in Asia
Overview of the crisis
The Asian Financial Crisis was a period of financial crisis that affected much of Asia beginning in July 1997, and raised fears of a worldwide economic meltdown (financial contagion). It is also commonly referred to as the IMF crisis.
The crisis started in Thailand with the financial collapse of the Thai baht caused by the decision of the Thai government to float the baht, cutting its peg to the USD, after exhaustive efforts to support it in the face of a severe financial overextension that was in part driven by the real estate sector. At the time, Thailand had acquired a burden of foreign debt that made the country effectively bankrupt even before the collapse of its currency. As the crisis spread, most of Southeast Asia and Japan saw slumping currencies, devalued stock markets and other asset prices, and a precipitous rise in private debt.
Although there has been general agreement on the existence of a crisis and its consequences, there is argument as to the causes of the crisis, as well as its scope and resolution. Indonesia, South Korea and Thailand were the countries most affected by the crisis. Hong Kong, Malaysia, Laos and the Philippines were also hurt by the slump. The People's Republic of China, India, Taiwan, Singapore, Brunei and Vietnam were less affected, although all suffered from a loss of demand and confidence throughout the region.
Foreign debt-to-GDP ratios rose from 100% to 167% in the four largest ASEAN economies during 1993-1996 and shot up beyond 180% during the worst times of the crisis. In Korea, the ratios rose from 13-21% and then as high as 40%, while the other Northern NICs (Newly Industrialized Countries) fared much better. Only in Thailand and Korea did debt service-to-exports ratios rise.
Although most of the governments of Asia had seemingly sound fiscal policies, the International Monetary Fund (IMF) stepped in to initiate a $40 billion program to stabilize the currencies of South Korea, Thailand, and Indonesia, economies particularly hard hit by the crisis. The efforts to stem a global economic crisis did little to stabilize the domestic situation in Indonesia, however. After 30 years in power, President Suharto was forced to step down in May 1998 in the wake of widespread rioting that followed sharp price increases caused by a drastic devaluation of the rupiah. The effects of the crisis lingered through 1998. In the Philippines growth dropped to virtually zero in 1998. Only Singapore and Taiwan proved relatively insulated from the shock, but both suffered serious hits in passing, the former more so due to its size and geographical location between Malaysia and Indonesia. By 1999, however, analysts saw signs that the economies of Asia were beginning to recover.
Background
Until 1997, Asia attracted almost half of the total capital inflow from developing countries. The economies of Southeast Asia in particular maintained high interest rates attractive to foreign investors looking for a high rate of return. As a result the region's economies received a large inflow of money and experienced a dramatic run-up in asset prices. At the same time, the regional economies of Thailand, Malaysia, Indonesia, Singapore, and South Korea experienced high growth rates, 8-12% GDP, in the late 1980s and early 1990s. This achievement was widely acclaimed by financial institutions including the IMF and World Bank, and was known as part of the "Asian economic miracle".
In 1994, noted economist Paul Krugman published an article attacking the idea of an "Asian economic miracle". He argued that East Asia's economic growth had historically been the result of capital investment, leading to growth in productivity. However, total factor productivity had increased only marginally or not at all. Krugman argued that only growth in total factor productivity, and not capital investment, could lead to long-term prosperity. Krugman's views would be seen by many as prescient after the financial crisis had become full-blown, although he himself stated that he had not predicted the crisis nor foreseen its depth.
The causes of the debacle are various and debateable. Thailand's economy developed into a bubble fuelled by "hot money". More and more was required as the size of the bubble grew. The same type of situation happened in Malaysia, although Malaysia had better political leadership, and Indonesia, which had the added complication of what was called "crony capitalism". The short-term capital flow was expensive and often highly conditioned for quick profit. Development money went in a largely uncontrolled manner to certain people only, not particularly the best suited or most efficient, but those closest to the central power.
At the time of the mid-1990s, Thailand, Indonesia and South Korea had large private current account deficits and the maintenance of fixed exchange rates encouraged external borrowing and led to excessive exposure to foreign exchange risk in both the financial and corporate sectors. In the mid-1990s, two factors began to change their economic environment. As the U.S. economy recovered from a recession in the early 1990s, the U.S. Federal Reserve Bank under the leadership of Alan Greenspan began to raise U.S. interest rates to head off inflation. This made the U.S. a more attractive investment destination relative to Southeast Asia, which had attracted hot money flows through high short-term interest rates, and raised the value of the U.S. dollar, to which many Southeast Asian nations' currencies were pegged, thus making their exports less competitive. At the same time, Southeast Asia's export growth slowed dramatically in the spring of 1996, deteriorating their current account position.
Some economists note the impact of China on the real economy as a contributing factor to ASEAN nations' export growth slowdown, although these economists maintain the main cause of the crises was excessive real estate speculation. China had begun to compete effectively with other Asian exporters particularly in the 1990s after the implementation of a number of export-oriented reforms. Most importantly, the Thai and Indonesian currencies were closely tied to the dollar, which was appreciating in the 1990s. Western importers sought cheaper manufacturers and found them, indeed, in China whose currency was depreciated relative to the dollar. Other economists dispute this claim noting that both ASEAN and China experienced simultaneous rapid export growth in the early 1990s.
Another point of view is that the Asian crisis was created not by market psychology or technology, but by policies that distorted incentives within the lender-borrower relationship. The resulting large quantities of credit that became available generated a highly-leveraged economic climate, and pushed up asset prices to an unsustainable level. These asset prices eventually began to collapse, causing individuals and companies to default on debt obligations. The resulting panic among lenders led to a large withdrawal of credit from the crisis countries, causing a credit crunch and further bankruptcies. In addition, as investors attempted to withdraw their money, the exchange market was flooded with the currencies of the crisis countries, putting depreciative pressure on their exchange rates. In order to prevent a collapse of the currency values, these countries' governments were forced to raise domestic interest rates to exceedingly high levels (to help diminish the flight of capital by making lending to that country relatively more attractive to investors) and to intervene in the exchange market, buying up any excess domestic currency at the fixed exchange rate with foreign reserves. Neither of these policy responses could be sustained for a long period of time. Very high interest rates, which can be extremely damaging to an economy that is relatively healthy, wreaked further havoc on economies in an already fragile state, while the central banks were haemorrhaging foreign reserves, of which they had finite amounts. When it became clear that the tide of capital fleeing these countries was not to be stopped, the authorities ceased defending their fixed exchange rates and allowed their currencies to float. The resulting depreciated value of those currencies meant that foreign currency-denominated liabilities grew substantially in domestic currency terms, causing more bankruptcies and further deepening of the crisis.
Other economists, including Joseph Stiglitz and Jeffrey Sachs, have downplayed the role of the real economy in the crisis compared to the financial markets due to the speed of the crisis. The rapidity with which the crisis happened has prompted Sachs and others to compare it to a classic bank run prompted by a sudden risk shock. Sachs pointed to strict monetary and contractory fiscal policies implemented by the governments on the advice of the IMF in the wake of the crisis, while Frederic Mishkin points to the role of asymmetric information in the financial markets that led to a "herd mentality" among investors that magnified a relatively small risk in the real economy. The crisis had thus attracted interest from behavioural economists interested in market psychology.
Another possible cause of the sudden risk shock may also be attributable to the handover of Hong Kong sovereignty on July 1, 1997. During the 1990s, hot money flew into the Southeast Asia region but investors were often ignorant of the actual fundamentals or risk profiles of the respective economies. The uncertainty regarding the future of Hong Kong led investors to shrink even further away from Asia, exacerbating economic conditions in the area and subsequently leading to the devaluation of the Thai baht on July 2, 1997.
The foreign ministers of the 10 ASEAN countries believed that the well co-ordinated manipulation of currencies was a deliberate attempt to destabilize the ASEAN economies. Former Malaysian Prime Minister Mahathir Mohamad accused George Soros of ruining Malaysia's economy with "massive currency speculation." Soros appeared to have had his bets in against the Asian currency devaluations, incurring a loss when the crisis hit. At the 30th ASEAN Ministerial Meeting held in Subang Jaya, Malaysia, they issued a joint declaration on 25 July 1997 expressing serious concern and called for further intensification of ASEAN's cooperation to safeguard and promote ASEAN's interest in this regard. Coincidentally, on that same day, the central bankers of most of the affected countries were at the EMEAP (Executive Meeting of East Asia Pacific) meeting in Shanghai, and they failed to make the 'New Arrangement to Borrow' operational. A year earlier, the finance ministers of these same countries had attended the 3rd APEC finance ministers meeting in Kyoto, Japan on 17 March 1996, and according to that joint declaration, they had been unable to double the amounts available under the 'General Agreement to Borrow' and the 'Emergency Finance Mechanism'. In this regard, the crisis could be seen as the failure to adequately build capacity in time to prevent currency manipulation. This hypothesis enjoyed little support among economists, however, who argue that no single investor could have had enough impact on the market to successfully manipulate the currencies' values. In addition, the level of organization necessary to coordinate a massive exodus of investors from Southeast Asian currencies in order to manipulate their values rendered this possibility remote.
Role of International Monetary Fund
The magnitude and the severity of the collapses involved meant that outside intervention, considered by many as a new kind of colonialism, became urgently needed. Since the countries melting down were among not only the richest in their region, but in the world, and since hundreds of billions of dollars were at stake, any response to the crisis had to be cooperative and international, in this case through the International Monetary Fund (IMF). The IMF created a series of bailouts or rescue packages for the most affected economies to enable affected nations to avoid default, tying the packages to reforms that were intended to make the restored Asian currency, banking, and financial systems as similar as that of the United States and Europe as possible. In other words, the IMF's support was conditional on a series of drastic economic reforms influenced by neo-liberal economic principles called a "structural adjustment package" (SAP). The SAPs imposed on crisis-struck nations to cut back on government spending to reduce deficits, allow insolvent banks and financial institutions to fail, and aggressively raise interest rates. The reasoning was that these steps would restore confidence in the nations' fiscal solvency, penalize insolvent companies, and protect currency values. Above all, it was stipulated that IMF-provided capital had to be administered rationally in the future, with no favoured parties receiving funds by preference.
There were to be adequate government controls set up to supervise all financial activities, ones that were to be independent, in theory, of private interest. Insolvent institutions had to be closed, and insolvency itself had to be clearly defined. In short, exactly the same kinds of financial institutions found in the United States and Europe had to be created in Asia, as a condition for IMF support. In addition, financial systems had to become transparent, having to provide the kind of reliable financial information used in the West to make sound financial decisions.
However, the greatest criticism of the IMF's role in the crisis was targeted towards its response. As country after country fell into crisis, many local businesses and governments that had taken out loans in US dollars, which suddenly became much more expensive relative to the local currency which formed their earned income, found themselves unable to pay their creditors. The dynamics of the situation were closely similar to that of the Latin American debt crisis. The effects of the SAPs were mixed and their impact controversial. Critics, however, noted the contractionary nature of these policies, arguing that in a recession, the traditional Keynesian response was to increase government spending, prop up major companies, and lower interest rates. The reasoning was that by stimulating the economy and staving off recession, governments could restore confidence while preventing economic pain. They pointed out that the U.S. government had pursued expansionary policies, such as lowering interest rates, increasing government spending, and cutting taxes, when the United States itself entered a recession in 2001.
Although such reforms were, in most cases, long needed, the countries involved ended up undergoing an almost complete political and financial restructuring. They suffered permanent currency devaluations, massive numbers of bankruptcies, collapses of whole sectors of once-booming economies, real estate busts, high unemployment, and social unrest. For most of the countries involved, IMF intervention has been roundly criticized. The role of the International Monetary Fund was so controversial during the crisis that many locals called the financial crisis the "IMF crisis".
Looking back many commentators criticized the IMF for encouraging the developing economies of Asia down the path of "fast track capitalism", meaning liberalization of the financial sector (elimination of restrictions on capital flows); maintenance of high domestic interest rates in order to suck in portfolio investment and bank capital; and pegging of the national currency to the dollar to reassure foreign investors against currency risk. In other words, that the IMF itself is seen as the cause of the crisis.
Consequences of the Asian financial crisis
In Asia:
The crisis had significant macro-level effects, including sharp reductions in values of currencies, stock markets, and other asset prices of several Asian countries. The nominal US dollar GDP of ASEAN fell by US$9.2 billion in 1997 and $218.2 billion (31.7%) in 1998. In Korea, the $170.9 billion fall in 1998 was equal to 33.1% of the 1997 GDP. Many businesses collapsed, and as a consequence, millions of people fell below the poverty line in 1997-1998. Indonesia, South Korea and Thailand were the countries most affected by the crisis.
The economic crisis also led to political upheaval, most notably culminating in the resignations of President Suharto in Indonesia and Prime Minister General Chavalit Yongchaiyudh in Thailand. There was a general rise in anti-Western sentiment, with George Soros and the IMF in particular singled out as targets of criticisms. Heavy U.S. investment in Thailand ended, replaced by mostly European investment, although Japanese investment was sustained. Islamic and other separatist movements intensified in Southeast Asia as central authorities weakened.
More long-term consequences included reversal of the relative gains made in the boom years preceding the crisis. Nominal US dollar GDP per capital fell 42.3% in Indonesia in 1997, 21.2% in Thailand, 19% in Malaysia, 18.5% in Korea and 12.5% in the Philippines. The CIA World Factbook reported that the per capita income measured by purchasing power parity declined from $8,800 to $8,300 in Thailand between 1997 and 2005; from $4,600 to $3,700 in Indonesia; and from $11,100 to $10,400 in Malaysia. Over the same period, world per capita income rose from $6,500 to $9,300. Indeed, the CIA's analysis asserted that the economy of Indonesia was still smaller in 2005 than it had been in 1997, suggesting an impact on that country similar to that of the Great Depression. Within East Asia region, the bulk of investment and a significant amount of economic weight shifted from Japan and ASEAN to China and India.
The crisis has been intensively analyzed by economists for its scope, speed, and dynamism; it affected dozens of countries, had a direct impact on the livelihood of millions, happened within the course of a mere few months, and at each stage of the crisis leading economists, in particular the international institutions, seemed a step behind. Perhaps more interesting to economists was the speed with which it ended, leaving most of the developed economies unharmed. These curiosities have prompted an explosion of literature about financial economics and a litany of explanations why the crisis occurred. A number of critiques have been put against the conduct of the IMF during the crisis, including one by former World Bank economist Joseph Stiglitz. Politically there were some benefits of the crisis. In several countries, particularly South Korea and Indonesia, there was renewed push for improved corporate governance. Rampaging inflation weakened the authority of the Suharto regime and led to its toppling in 1998, as well as accelerating East Timor's independence.
Outside Asia
After the Asian crisis, international investors were reluctant to lend to developing countries, leading to economic slowdowns in developing countries in many parts of the world. The powerful negative shock also sharply reduced the price of oil, which reached a low of $8 per barrel towards the end of 1998, causing a financial pinch in OPEC nations and other oil exporters. This reduction in oil revenue contributed to the 1998 Russian financial crisis, which in turn caused Long-Term Capital Management in the United States to collapse after losing $4.6 billion in 4 months. A wider collapse in the financial markets was avoided when Alan Greenspan and the Federal Reserve Bank of New York organized a $3.625 billion bail-out. Major emerging economies such as Brazil and Argentina also fell into crisis in the late 1990s.
The crisis in general was part of a global backlash against the Washington Consensus and institutions such as the IMF and World Bank, which simultaneously became unpopular in developed countries following the rise of the anti-globalization movement in 1999. Four major rounds of world trade talks since the crisis, in Seattle, Doha, Cancún, and Hong Kong, have failed to produce a significant agreement as developing countries have become more assertive, and nations are increasingly turning toward regional or bilateral FTAs (Free Trade Agreements) as an alternative to global institutions. Many nations learned from this, and quickly built up foreign exchange reserves as a hedge against attacks, including Japan, China and South Korea. Pan Asian currency swaps were introduced in the event of another crisis. However, interestingly enough, such nations as Brazil, Russia, and India as well as most of East Asia began copying the Japanese model of weakening their currencies, restructuring their economies so as to create a current account surplus to build large foreign currency reserves. This has led to an ever increasing funding for US treasury bonds, allowing or aiding housing in 2001-2005 and stock asset bubbles in 1996-2000 to develop in the United States.
| This article uses material from the Wikipedia article "1997 Asian Financial Crisis" |
<< Global Financial Crisis main page