Wh at c aused th e As ian

Fin ancial c risis?

Thu Thi Hoang: Macroeconomic weaknesses
John Parker: Financial intermediaries & “The Bubble”
Mark Steingraeber
Bernard Villanueava
Brian Ikihara
 Asi an financial cri sis
overvi ew
The Asian financial crisis is considered to have started on July 2, 1997
with the devaluation of the Thai baht and ask IMF for assistance.

Malaysia abandons the peg and blames the speculators on July 14

Philippines seek assistance form IMF

Indonesia floats on August 14, go to the IMF on October 8

Repeated speculative attacks on Hong Kong dollar unsuccessful, but

stock market plunges between October 20-23

Global stock market decline on October 27

S. Korea devalue Nov. 28 and ask for IMF assistance

Spread over other Asia countries

Macro ec ono mic w eakn esse s

• Large current account deficit

• Large capital inflows

• Large exchange rate depreciations

• Bank lending
Cu rrent account def ici ts
 Large capi tal infl ow s

• Large capital inflows,

especially those
deriving from foreign
borrowing.

• These inflows
equivalent 1990-1996
– Korea: 2.5% of GDP
– Thailand: 10%
– Indonesia: 3.5%
 La rge capi tal inf lo ws

• They were encouraged

by high economic
growth, low inflation
and relatively healthy
fiscal performance
(table1 and figure 2)
Large ex cha nge rat e d ep rec iatio n (to the US
Dollar)

Period average
Source: International Financial Statistics ( IMF)

1990 1991 1992 1993 1994 1995 1996 1997

Korea 707 733 780 802 803 771 804 951

Indonesia 1824 1950 2029 2087 2160 2248 2342 2909

Malaysia 2.70 2.75 2.55 2.57 2.62 2.50 2.52 2.81

Philippines 23.3 27.4 25.51 27.12 26.42 25.7 26.22 29.47

Thailand 25.5 25.5 25.40 25.32 25.15 24.9 25.34 31.36

Large exchange rate depreciations (cont.)

Inflexible exchange rate regimes complicated

macroeconomic management and increased vulnerability.

Nominal exchange rate had depreciated in a predictable

manner in Indonesia, and was closely linked to the U.S in
Malaysia, the Philippines and Thailand.

The crisis countries were vulnerable to capital outflows and

exchange rate devaluations because of the significant
amount of short term foreign currency debt, which was
mostly unhedged.
 Bank lendi ng

• Private credit sector

in nominal terms
expanded rapidly
during the 1990s, at
an average rate of
15 to 20% compared
to inflation rates of
3-10%.
 Bank lending (cont.)

• Bank lending relied collateral rather than credit

assessment and cash flow analysis, making banks
vulnerable to excessive risk and declines in asset
values.
What caused the Asian Financial Crisis Part II
Two conventional models.

“The First Generation” crisis model (Krugman 1979; Flood and

Garber 1984) describes a government with persistent money
financed budget deficits that uses its limited reserves to peg its
exchange rate. This will of course be ultimately unsustainable. At
some point a speculative attack will occur when investors believe
collapse is imminent.

“The Second Generation” crisis model (Obstfeld 1994, 1995)

describes a government making a tradeoff between short-run
macroeconomic flexibility and longer- term credibility. In this
model higher interest rates are required to defend parity if the
market defense of the peg will ultimately fail. A speculative attack
can develop either as a result of an expected future failure or as a
“self-fulfilling prophecy.”
As useful as these two models have been describing most
historical currency crisis; they fail to explain the AFC.
First, none of the governments were engaged in irresponsible
monetary expansion, in fact their inflation rates were quite low.
On the eve of the crisis all of the governments were more or less
in fiscal balance.
Second, the Asian countries did not have a troubling level of
unemployment. Therefore there did not seem to be any pressure
to abandon the fixed exchange rate in favor of monetary
expansion.

Third, there was already a boom bust cycle in the asset

markets that preceded the currency crisis.

Fourth, in all countries involved in the AFC, financial

intermediaries seem to have been central players in the crisis. In
Thailand so called “finance companies” – nonbank
intermediaries that borrowed short-term money then lent to
speculative investors played a crucial role.
 What ar e Fi nanci al Intermedi ari es
and what rol e di d t hey pl ay in the
cr isi s?
“financial intermediaries” were institutions perceived as having
implicit government guarantees but were in most part
unregulated and subject to sever “moral hazard” problems

Unrestrained risky lending by these institutions caused inflation of

asset prices (but not consumer goods). This over pricing of
assets was sustained by a sort of circular process of
reinforcement. The proliferation of risky lending drove up asset
prices making the collateral position of the lending institutions
seem stronger than it actually was. Also, the appearance of
soundness of the position of financial institutions further
increased risky loans putting even more upward pressure on asset
prices.
 Then t he bubble burst!

The reverse of the upward spiral occurred with a vengeance. Falling

asset prices quickly made financial institutions insolvent forcing
them to cease lending which led to a further acceleration of asset
depreciation. This reinforcing circular decline can explain the
contagious nature of the crisis to countries without visible economic
links. Other countries where the asset bubble had not yet burst
suffered a decline of investor confidence because of the suddenness,
severity and unpredictableness of the Thai crises which in turn led to
self fulfillment of the crisis in that country. The loss of investor
confidence caused a decline in asset prices which then followed the
reinforcing downward spiral of asset prices and collapse of financial
intermediaries as in Thailand.

Although the moral hazard/asset bubble view is not the full story
of the cause of the crises, it is surely a leading contender as a
primary cause.
How do w e res ol ve baf fling nat ure
of the AFC :
The problem was off the government balance sheet. The fact that
government guarantees of the financial institutions was at best
implicit, made these liabilities invisible until after the fact. Even
the implicit guarantees of the US S&Ls in the 1980s was not a
visible government liability until they actually failed.

The boom and bust cycles of the asset market preceded the
currency crisis because the financial crisis was the real cause of
the whole process with currency fluctuations a result rather than a
cause of the AFC.

The AFC was able to spread without specific exogenous shock to

other Asian economies because of vulnerability to self-fulfilling
pessimism which generated a downward spiral of asset deflation
and disappearance of a financial intermediation structure.