CRS Report THE 1997-98 ASIAN FINANCIAL CRISIS Dick K.

Nanto, Specialist in Industry and Trade Economics Division February 6, 1998 Summary The Asian financial crisis involves four basic problems or issues: (1) a shortage of foreign exchange that has caused the value of currencies and equities in Thailand, Indonesia, South Korea and other Asian countries to fall dramatically, (2) inadequately developed financial sectors and mechanisms for allocating capital in the troubled Asian economies, (3) effects of the crisis on both the United States and the world, and (4) the role, operations, and replenishment of funds of the International Monetary Fund. The Asian financial crisis was initiated by two rounds of currency depreciation that have been occurring since early summer 1997. The first round was a precipitous drop in the value of the Thai baht, Malaysian ringgit, Philippine peso, and Indonesian rupiah. As these currencies stabilized, the second round began with downward pressures hitting the Taiwan dollar, South Korean won, Brazilian real, Singaporean dollar, and Hong Kong dollar. Governments have countered the weakness in their currencies by selling foreign exchange reserves and raising interest rates, which, in turn, have slowed economic growth and have made interestbearing securities more attractive than equities. The currency crises also has revealed severe problems in the banking and financial sectors of the troubled Asian economies. The International Monetary Fund has arranged support packages for Thailand, Indonesia, and South Korea. The packages include an initial infusion of funds with conditions that must be met for additional loans to be made available. This financial crisis is of interest to the U.S. government for several reasons. First, attempts to resolve the problems are led by the IMF with cooperation from the World Bank and Asian Development Bank and pledges of standby credit from the Exchange Stabilization Fund of the United States. Second, financial markets are interlinked. What happens in Asian financial markets also affects U.S. markets. Third, Americans are major investors in the region, both in the form of subsidiaries of U.S. companies and investments in financial instruments. Fourth, the currency turmoil affects U.S. imports and exports

as well as capital flows and the value of the U.S. dollar; the U.S. deficit on trade is now rising as these countries import less and export more. Fifth, the crisis is causing economic turmoil that is exposing weaknesses in many financial institutions in Asia; some have gone bankrupt. The economic problems of the troubled Asian economies are adversely affecting the United States, Japan, and others. The U. S. Congress is likely to consider the Asian financial crisis within three broad legislative contexts. The first is in the financing and scope of the activities of the IMF. This includes legislation to provide the IMF with an increase in its quotas or capital subscriptions, New Arrangements to Borrow, an allocation of Special Drawing Rights, and an amendment to the IMF's Articles of Agreement. The second legislative context is in the impact of the crisis on the U.S. economy and American financial institutions. Forecasters foresee a decline in U. S. growth and an increase in the U.S. trade deficit because of the crisis. The third context is in efforts to liberalize trade and investment in the world. Chronology of the Asian Financial Crisis Early May (1997) - Japan hints that it might raise interest rates to defend the yen. The threat never materializes, but it shifts the perceptions of global investors who begin to sell Southeast Asian currencies and sets off a tumble both in currencies and local stock markets. July 2 - After using $33 billion in foreign exchange, Thailand announces a managed float of the baht. The Philippines intervenes to defend its peso. July 18 - IMF approves an extension of credit to the Philippines of $1.1 billion. July 24 - Asian currencies fall dramatically. Malaysian Prime Minister Mahathir attacks "rogue speculators" and later points to financier George Soros. Aug. 13-14 - The Indonesian rupiah comes under severe pressure. Indonesia abolishes its system of managing its exchange rate through the use of a band. Aug. 20 - IMF announces $17.2 billion support package for Thailand with $3.9 billion from the IMF. Aug. 28 - Asian stock markets plunge. Manila is down 9.3%, Jakarta 4.5%. Sep. 4 - The peso, Malaysian ringgit, and rupiah continue to fall. Sep. 20 - Mahathir tells delegates to the IMF/World Bank annual conference in Hong Kong that currency trading is immoral and should be stopped. Sep. 21 - George Soros says, "Dr Mahathir is a menace to his own country." Oct. 8 - Rupiah hits a low; Indonesia says it will seek IMF assistance.

Oct. 14 - Thailand announces a package to strengthen its financial sector. Oct. 20-23 - The Hong Kong dollar comes under speculative attack; Hong Kong aggressively defends its currency. The Hong Kong stock market drops, while Wall Street and other stock markets also take severe hits. Oct. 28+ - The value of the Korean won drops as investors sell Korean stocks. Nov. 5 - The IMF announces a stabilization package of about $40 billion for Indonesia. The United States pledges a standby credit of $3 billion. Nov. 3-24 - Japanese brokerage firm (Sanyo Securities), largest securities firm (Yamaichi Securities), and 10* largest bank (Hokkaido Takushoku) collapse. Nov. 21 - South Korea announces that it will seek IMF support. Nov 25 - At the APEC Summit, leaders of the 18 Asia Pacific economies endorse a framework to cope with financial crises. Dec 5 - Malaysia imposes tough reforms to reduce its balance of payments deficit. Dec 3 - Korea and IMF agree on $57 billion support package. Dec 18 - Koreans elect opposition leader Kim, Dae-jung as new President. Dec 25 - IMF and others provide $10 billion in loans to South Korea. Jan 6 - Indonesia unveils new budget that does not appear to meet IMF austerity conditions. Value of rupiah drops. Jan 8 - IMF and S. Korea agree to a 90-day rollover of short-term debt. Jan 12 - Peregrine Investments Holdings of Hong Kong collapses. Japan discloses that its banks carry about $580 billion in bad or questionable loans. Jan 15 - IMF and Indonesia sign an agreement strengthening economic reforms. Jan 29 - South Korea and 13 international banks agree to convert $24 billion in short-term debt, due in March 1998, into government-backed loans. Jan 31 - South Korea orders 10 of 14 ailing merchant banks to close. Feb 2- The sense of crisis in Asia ebbs. Stock markets continue recovery. The 1997-98 Asian Financial Crisis Introduction The Asian financial crisis involves four basic problems or issues: (1) a shortage of foreign exchange in Thailand, Indonesia, South Korea and other Asian countries that has caused the value of currencies and equities to fall dramatically, (2) inadequately developed financial sectors and mechanisms for allocating capital in the troubled Asian economies, (3) effects of the crisis on both the United States and the world, and

(4) the role, operations, and replenishment of funds of the International Monetary Fund. The crisis was initiated by two rounds of currency depreciation that began in early summer 1997. The first round was a precipitous drop in the value of the Thai baht, Malaysian ringgit, Philippine peso, and Indonesian rupiah (see Figure 1). As these currencies stabilized at lower values, the second round began with downward pressures hitting the Taiwan dollar, South Korean won, Brazilian real, Singaporean dollar, and Hong Kong dollar. (See Figure 2.)In countering the downward pressures on currencies, governments have sold dollars from their holdings of foreign exchange reserves, bought their own currencies, and have raised interest rates to foil speculators and to attract foreign capital. The higher interest rates, in turn, have slowed economic growth and have made interest-bearing securities more attractive than equities. Stock prices have fallen. In November 1997, this decline in stock values was transmitted to other stock markets in the world, although U. S. and European markets have subsequently recovered. This financial crisis is of interest to the U.S. government for several reasons. First, financial markets are interlinked. What happens in Asian financial markets also may affect U.S. markets. Second, American banks and companies are significant lenders and/or investors in the region, in terms of bank loans, subsidiaries of U. S. companies, and investments in financial instruments. Third, attempts to resolve the problems have been led by the International Monetary Fund (IMF) with cooperation from the World Bank and Asian Development Bank. Some legislative issues dealing with IMF funding and operations were deferred by the 105* Congress at the close of its recent session. In 1998, Congress is considering New Arrangements to Borrow by the IMF, a proposed increase in IMF quotas or capital subscriptions, and a proposed amendment to the IMF's Articles of Agreement. Congress also may intensify its oversight U.S. activities in the IMF. The fourth reason that the Asian financial crisis is of interest to the United States is that the turmoil affects U.S. imports and exports as well as capital flows and the value of the U.S. dollar. The U.S. deficit on trade is now rising as these countries import less and export more. Fifth, the crisis is exposing weaknesses in many financial institutions in Asia. Some have gone bankrupt. The economic problems of the so-called

Asian Tigers not only are adversely affecting the economies of Japan and others in the region, but, to some extent, an economic slowdown could spread to Latin America and the United States. Sixth, the crisis may impede the progress of trade and investment liberalization under the World Trade Organization and the Asia Pacific Economic Cooperation (APEC) forum. So far, the International Monetary Fund has arranged support packages for Thailand, Indonesia, and South Korea, and extended and augmented a credit to the Philippines to support its exchange rate and other economic policies. The three support packages are summarized in Table 1. The total amounts of the packages are approximate because the IMF lends funds denominated in special drawing rights (SDRs), and because pledged amounts may change as circumstances change. The support package for Thailand was $17.2 billion, for Indonesia about $40 billion, and for South Korea $57 billion. The United States pledged $3 billion for Indonesia and $5 billion for South Korea from its Exchange Stabilization Fund (ESF) as a standby credit that may be tapped in an emergency. The U. S. Treasury lends money from the ESF at appropriate interest rates and with what it considers to be proper safeguards to limit the risk to American taxpayers. The support packages are initiated by a request from the country experiencing financial difficulty. This request then requires an assessment by IMF officials of the conditions in the requesting nation. If a support package is approved, the IMF usually begins with an initial loan of hard currency to the borrowing nation. Subsequent amounts are made available (usually quarterly) only if certain performance targets are met and program reviews are completed. If the financial situation continues to deteriorate, commitments for funds that have been pledged by the World Bank, Asian Development Bank and certain nations may be tapped. The funds borrowed by the recipient country usually go into the central bank' s foreign exchange reserves. These reserves are used to supply foreign exchange to buyers, both domestic and international. Table 1. IMF Financial Support Packages (Amounts in U.S.$Billion) Thailand Indonesia South Korea Date Approved

(1997)August 20 November 5 December 4 Total Pledged $17.2 $40 $57 IMF $3.9 $10.1 $21.0 U. S. None $ 3.0 $5.0 World Bank $1.5 $ 4.5 $10.0 Asian Development $1.2 $ 3.5 $ 4.0 Bank Japan $4.0 $ 5.0 $10.0 Others $6.6 $26.0 $ 7.0 Change in Exchange Rate -38% -81% -50% (7/1197- 1/22/98) Change in Stock Market -26% -40% -30% (7/1/97-1/19/98) Source: International Monetary Fund, Dialogue Database, Wall Street Journal, Financial Times. In addition to support packages by the IMF, other international organizations have been addressing the Asian financial crisis. On November 3-5, 1997, the Group of Fifteen developing nations met in Malaysia and developed a plan to avert renewed currency turbulence. In preparation for the Asia Pacific Economic Cooperation (APEC) summit meeting, senior finance officials of APEC met in Manila on November 18-19 and developed a framework for dealing with financial crises in the region. This Manila Framework was endorsed by the eighteen leaders of the economies of APEC at the forum's annual summit in Vancouver, BC, on November 25, 1997. The Manila Framework recognized that the role of the IMF would remain central and included enhanced regional surveillance, intensified economic and technical cooperation to improve domestic financial systems regulatory capacities, adoption of new IMF mechanisms on appropriate terms in support of strong adjustment programs, and a cooperative financing arrangement to supplement, when necessary IMF resources. 1 On December 1, 1997, the finance ministers of the Association of Southeast Asian Nations (ASEAN-Indonesia, the Philippines, Singapore, Thailand, Malaysia, Myanmar, Brunei, Laos, and Vietnam) agreed to make additional funding available for any future bailouts for troubled economies in the region. It would be provided only if a country accepted an IMF support package and if ASEAN members consider IMF funds to be inadequate.2 On December 15, 1997, ASEAN heads of state endorsed the Manila Framework, efforts of the

IMF, decided to develop a regional surveillance mechanism that would emphasize preventive efforts to avoid financial crises, and reaffirmed their commitment to maintain an open trade and investment environment in ASEAN.3 The IMF and Stabilization Packages The International Monetary Fund has been the key player in coordinating support packages for the troubled Asian economies. The IMF says that it has learned from the Mexican Peso crisis in 1995 and had instituted emergency procedures that enabled it to respond to each the crises in each Asian country in record time. The major objectives of the IMF are to promote stability, balanced expansion of trade, and growth, but because of the Asian financial crisis, it has deepened its activities in four directions.4 They are: strengthening IMF surveillance over member countries' policies, helping to strengthen the operation of financial markets (technical assistance), providing policy advice and financial assistance quickly when crises emerge, and helping to ensure that no member country is marginalized (being left behind in the expansion of world trade and being unable to attract significant amounts of private investment). At the September 1997 annual meeting of the IMF in Hong Kong, the Board of Governors approved moving ahead to develop an amendment of the IMF Articles of Agreement to make the liberalization of international capital flows one of the purposes of the Fund. For the United States, this change would presumably require Congressional approval. The Asian financial crisis also has raised several questions pertaining to IMF operations. The first is whether such crises have increased in scale and whether IMF resources are sufficient to cope with them. (IMF funding is discussed in the final section of this report on issues for Congress.) The second is whether the Fund's willingness to lend in a crisis contributes to moral hazard (a tendency for a potential recipient country to behave recklessly knowing that the IMF will likely bail them out in an emergency). The third is whether the contagion of financial crises can be stopped effectively. The fourth is conditionalitywhether the changes in economic policy and performance targets that the IMF requires of the recipient countries are appropriate and effective. The fifth is transparency-whether the IMF releases sufficient

information to the public, including investors, on its program design and provisions imposed as a condition for borrowing allow for accurate assessment and accountability. The sixth is prevention-whether the IMF has sufficient leverage over non-borrowing member countries to prevent financial crises from occurring.5 With respect to the scale of financial crises, it is clear that recent liberalization of capital markets and advances in telecommunications have increased the scale of financial crises. The size of the support packages for South Korea and Indonesia have been unprecedented. The question is whether the IMF has sufficient resources to handle more financial crises, particularly if they occur simultaneously. With respect to moral hazard, the opinion of the IMF is that governments in trouble usually are too slow in approaching the Fund for help because of the conditions the IMF places on such support. According to the IMF, the real moral hazard is not with governments engaging in unsound lending but that, because IMF support is available, the private sector may be too willing to lend. Private sector financial institutions know that a country in trouble will go to the Fund rather than default on international loans. 6 Others, moreover, assert that the IMF is perpetuating the moral hazard that lies at the heart of the problem for troubled economies like South Korea-the absence of bankruptcy. Some corporations in certain countries have not been allowed to fail because of political or other reasons. In the words of one commentator, "Capitalism without bankruptcy is like Christianity without hell. There is no systematic means of controlling sinful excesses."7 With respect to contagion, the track record of the IMF in stopping the spread of the financial crisis within Asia has not been reassuring. Outside of Asia, however, the crisis has yet to spread, although currencies in Brazil and other countries also have depreciated somewhat. With respect to IMF conditionality, this continues to be hotly debated with each IMF support package. Some claim the monetary and fiscal policies required by the IMF are too stringent and slow economic growth too much. The World Bank, in particular, reportedly fears that the slowdown in economic growth in the troubled Asian economies will only worsen their economic problems.8 With respect to transparency, critics of the IMF claim that the institution does not release sufficient

data to the public and investors who have financial interests in the success or failure of the IMF support packages and who need more information to devise effective strategies to cope with the crises.9 The IMF, however, does release more information now that it did previously. Also, the IMF may leave it to the borrowing country to release detailed information. With respect to prevention, the IMF has little leverage over member countries who are not borrowers. Countries also have to assess the possibility of a future crisis in light of immediate political exigenciesparticularly elections. For example, prior to the financial crisis in Thailand, even though the IMF might have warned the country that it was headed for trouble, it was difficult for the Thai leaders to muster the political support to restructure the 58 financial institutions that eventually became insolvent. The IMF Support Package for Thailand The support package for Thailand announced by the IMF on August 20, 1997, (eventually worth $17.2 billion) included: an IMF stand-by credit of up to SDR 2.9 billion 10 (about US$3 .9 billion) over the ensuing 34 months to support the government's economic program [Of the total, SDR 1.2 billion (about US$1.6 billion) was available immediately and a further SDR 600 million (about US$810 million) was to be made available after November 30, 1997, provided that end-September performance targets had been met and the first review of the program has been completed. Subsequent disbursements, on a quarterly basis, would be made available subject to the attainment of performance targets and program reviews.], loans of up to $1.5 billion from the World Bank, and loans of up to $1.2 billion from the Asian Development Bank. The package also included the following pledges credit of $4 billion from Japan' s Export-Import Bank, and credits of $1 billion each from Australia, Hong Kong, Malaysia, Singapore, and China, and credits of $0.5 billion from Indonesia, Brunei, and Korea (Korea's was later retracted). According to the IMF, the proceeds from the credits extended by the IMF and the bilateral lenders are to be used solely to help finance the balance of payments gap in Thailand and to rebuild the official reserves of the Bank of

Thailand. ll The IMF also placed certain conditions on Thailand. These reportedly included that the country commit itself to maintaining foreign exchange reserves at $23 billion in 1997 and $25 billion in 1998, slash its current account deficit to about 5% of GDP in 1997 and to 3% of GDP in 1998, and show a budget surplus equal to 1% of its GDP in FY1998. The IMF Support Package for Indonesia For Indonesia, the IMF announced a support package on November 5, 1997, that totaled $40 billion. The package included first-line financing amounting to about $23 billion to include: 12 IMF standby credit of SDR 7.338 billion (about $10.14 billion) with SDR 2.2 billion (about $3.04 billion) available immediately and further disbursements after March 15, 1998, provided that certain targets have been met; technical assistance and loans from the World Bank of $4.5 billion, technical assistance and loans from the Asian Development Bank of $3.5 billion, and $5.0 billion from Indonesia's contingency reserves. In addition, a number of other countries or monetary authorities have committed to provide a second line of supplemental financing "in the event that unanticipated adverse external circumstances create the need for additional resources to supplement Indonesia's reserves and the resources made available by the IMF." These include: Japan-$5.0 billion, Singapore-$5.0 billion, United States-$3.0 billion $1.0 billion each from Australia, Malaysia, China, and Hong Kong. . Previously, Singapore also had promised an additional $5 billion to Indonesia in foreign exchange, if needed, to purchase rupiah. 13 Funds from the United States are in the form of a back-up line of credit from the Exchange Stabilization Fund 14 at appropriate interest rates. The U.S. Treasury characterized this as contingent financial support to be used as a temporary "second line of defense" in the event that unanticipated external pressures were to give rise to a need to supplement Indonesia' s own reserves and the resources made available by the IMF. Since the fund is under the control of the Secretary of the Treasury, use of its funds does not require congressional approval. Treasury, however, has indicated that if funds are disbursed, they would carry proper safeguards to limit the risk to American taxpayers.15

As part of the support package, Indonesia was required to restructure certain banks, dismantle a quasigovernmental monopoly on all commodities (except rice), cut fuel subsidies, increase electricity rates, increase the transparency of public policy and budget-making processes, and speed up privatization and reform of state enterprises. It was not required, however, to change its national car policy or aircraft development program. The IMF Support Package for South Korea The IMF support package for South Korea was announced in Seoul on December 3, 1997 and was formally approved by the IMF on the following day. It eventually consisted of $57 billion as follows: 16 * IMF three-year standby credit of SDR 15.5 billion (about $21 billion), World Bank-$10 billion, Asian Development Bank-$4 billion. United States-$5 billion from its Exchange Stabilization Fund,l7 Japan-$10 billion, $ 1 billion each from the United Kingdom, Germany, France, Australia, Canada, and Italy, additional support from Belgium, the Netherlands, ana Switzerland. The funds are contingent upon South Korea' s remaining in compliance with the IMF arrangement. In return for accepting the IMF emergency loans, Korea agreed to several conditions and reforms in order to strengthen its economy. On the macroeconomic side, the conditions included: reducing its current-account deficit to no more than 1% of GDP for 1998 and 1999 (about $5 billion), capping its yearly inflation rate at 5% in 1998 and 1999, building international reserves to more than two months of imports by the end of 1998, and recognizing that economic growth (in terms of GDP) for 1998 would likely fall from 6% to around 3%. In terms of financial restructuring, the IMF required a comprehensive restructuring and strengthening of Korea' s financial system in order to make it more sound, transparent, and efficient. The strategy comprised three broad elements: a clear and firm exit policy, strong market and supervisory discipline, and increased competition. The measures included: requiring that all banks that fail to meet the Basle Committee capital standards be restructured and recapitalized to include mergers and acquisitions by foreign institutions and losses by shareholders, replacing the government guarantee of bank deposits by the end of the year 2000 with a regular deposit insurance system, upgrading accounting and disclosure standards to include audits of financial statements of large

financial institutions and semi-annual disclosure of nonperforming loans, capital adequacy, and ownership structures and affiliations, requesting passage of legislation to make the Bank of Korea independent with price stability as its overriding mandate and setting up an agency to consolidate financial sector supervision, and allowing foreign banking and securities companies to establish affiliated companies in Korea by the middle of 1998. In terms of structural policies, the IMF package required the Korean government to take several measures. These included: setting a timetable in line with World Trade Organization commitments to eliminate trade-related subsidies, restrictive import licensing, and Korea's import diversification program (aimed at Japan), increasing to 50% (from 26%) the ceiling for foreign investment in listed Korean firms and further increasing it to 55% by the end of 1998, by the end of February 1998, taking steps to liberalize other capital account transactions, including restrictions on access by foreigners' to domestic money market instruments and corporate bond markets, and easing labor dismissal restrictions under mergers and acquisitions and corporate restructuring. 18 FrankSanders Amendment The support packages of the IMF appear to be subject to the requirements of the Frank-Sanders amendment (U.S.C. 22 262p-4p). Among its provisions, the Frank- Sanders amendment requires the U. S. Treasury to direct the U. S. Executive Directors of the International Financial Institutions (such as the IMF and World Bank) to use the voice and vote of the United States to urge the respective institution to adopt policies to encourage borrowing countries to guarantee internationally recognized worker rights and to include such rights as an integral part of the institution's policy dialogue with each borrowing country. In testimony before the House Banking Committee in November 1997, the U.S. Treasury indicated that it had "spoken out within the World Bank and IMF, in advancing the purposes of the FrankSanders Amendment, to promote measures that would help improve the conditions of workers in Indonesia, Thailand, and across the developing world.''l9 Others believe, however, that the IMF's Indonesian support package was not in accord with the Frank-Sanders Amendment.20 Bailout? IMF assistance to the above three countries has been criticized for "bailing out" commercial banks and private investors at the expense of other less-favored groups and U. S. taxpayers. The IMF insists, however, that its assistance has been provided to support programs that are designed to deal with economy wide, structural imbalances and not to protect commercial banks and private investors

from financial losses.21 A more stable exchange rate may contribute to a recovery on stock markets or better business conditions, but there is no IMF "bailout" of specific investors. As for bailouts of manufacturing or other nonfinancial corporations, the IMF claims that there are no provisions in the IMF-supported programs for public-sector guarantees, subsidies, or support for them. Shareholders and creditors bear losses, although individual governments may devise separate policies for dealing with such cases. Any company in need of foreign exchange, however, usually is better off when foreign exchange markets are stabilized. As for financial corporations, the IMF recognizes that governments often guarantee accounts of certain categories of depositors (deposit insurance). Liquidity support also can be provided to undercapitalized, but solvent, financial institutions. According to the IMF, however, such support normally requires that institutions be capable of actually being recapitalized and restructured to restore them to health.22 Imprudent lenders or investors in the recipient countries have not escaped real losses. In Korea, for example, the operations of 14 of 30 merchant banks have been suspended. The remaining merchant banks also are to be closed unless they submit rehabilitation plans. Two commercial banks in Korea also will be required to be recapitalized and restructured. In Indonesia, 16 insolvent banks have been closed, and weak but viable banks have been required to submit rehabilitation plans. In Thailand, 56 of 91 finance companies are to be liquidated. As for investors in equity markets, they also have incurred losses. In January 1998, U. S. Federal Reserve Chairman Alan Greenspan indicated that because of the financial crisis, foreign investors in Asian equities (excluding those in Japan) had lost an estimated $700 billionincluding $30 billion by Americans.23 Another aspect of moral hazard is whether the IMF support packages rescue creditors in New York Tokyo, and Europe from their poor lending decisions. There is little doubt that banks which have loans outstanding in Asia have much to gain by a return to stability in Asian financial markets. To the extent that the IMF support packages have contributed to that stability and to the extent that the infusion of

dollars by the IMF has enabled borrowers or others in need of foreign exchange to purchase more of it,

U.S. banks and other creditors have gained. Banks, however, still face large potential and real losses from their operations in Asia. For example, in 1997, the Asian turmoil reduced Citicorp's pretax earnings by about $250 million.24 The Bank of America reported that as of December 31, 1997, it had assets of $24.0 billion in Asia (up from $20.4 billion in December 1996), but net income from Asia had dropped from $224 million in 1996 to $218 million in 1997.25 During the fourth quarter of 1997, J.P. Morgan designated as nonperforming approximately $587 million of its total $5.4 billion in loans, swaps, and debt investment securities in Indonesia, Thailand, and South Korea. The bank reported charge-offs of $24 million during the quartermostly related to Asia, and considered about 60% of its total allowance for credit losses of $1 .081 billion to be related to exposures in the three troubled Asian countries.26 Effects on the U.S. Economy The Asian Financial Crisis affects the U.S. economy both in a macroeconomic and microeconomic sense. On the macroeconomic level, it likely will affect the U. S. growth rate, interest rates, balance of trade, and related variables. On a microeconomic level, it can affect specific industries, each in a different way that depends on their relationship to the troubled Asian economies. The mechanism by which the U.S. macroeconomy is affected is through trade and capital flows. The depreciation in the values of the South Korean won, Indonesian rupiah, Singaporean dollar, Thai baht, Philippine peso, Japanese yen, Taiwan dollar, and other Asian currencies (except for the Hong Kong dollar and Chinese RMB) combined with a slowing of growth and financial difficulties of banks and manufacturing corporations in these countries is expected to increase the U. S. trade deficit. In the Asian countries, the immediate effect of the change in the value of their currencies and outflows of

capital is to reduce their trade deficits, and, in some cases, to generate a trade surplus. This is already occurring in South Korea. Much of this increased trade surplus for Asia is likely to come at the expense of the United States. The second macroeconomic mechanism by which the Asian financial crisis affects the U.S. economy is through capital flows. As the contagion began and Asian banks and corporations began to face severe financial difficulties, a concern arose in the United States that Asian holders of American financial assets, particularly U.S. Treasury securities, might be forced to pull them out of the U. S. economy in order to generate much needed cash. It seems, however, that a "flight to quality" occurred instead. Both American and foreign investors withdrew liquid capital (by selling securities and not rolling over loans) from the troubled Asian countries and moved them into the United States. This has eased the upward pressure on U. S. interest rates and is likely to have a positive effect on U. S. economic growth. Economic Growth Forecasters project that U.S. economic growth will slow by 1.3 percentage points (or 34%) from 3.8% in 1997 to about 2.5% in 1998.2' (See Figure 3.) This U.S. slowdown is being caused primarily by two factors: the Asian financial crisis and tightness in U.S. labor markets. Most forecasters estimate that the Asian financial crisis will reduce U.S. growth in 1998 by 0.5 to 1.0 percentage point. A comparison of forecasts for U.S. economic growth made in January 1998 with those made before the onset of the Asian financial crisis in July 1997, however, reveals one unexpected result. The forecasts for economic growth made in January 1998, in most cases, were higher than those published in July 1997 before the crisis. The main reason for this seems to be that in mid-1997 forecasters were wary of the Federal Reserve Board's concern over the run-up in the U.S. stock market, tightening labor markets, and the likelihood that the Federal Reserve would raise U.S. interest rates. These concerns were eased by the correction in the U.S. stock market in October 1997 and by the financial turmoil in Asia. The rising U.S. trade deficit with Asia, therefore, is expected to be offset by the easing of upward pressures on

U.S. interest rates. Trade Deficit Forecasters expect the 1998 U.S. trade deficit to increase significantly because of the drop in the value of currencies in Asia, net capital inflows, and the slowdown in growth in those economies. (See Figure 4) The capital inflows into the United States and outflows from the troubled Asian economies imply that the respective current accounts 28 must move in the opposite direction. For the United States, a rise in the surplus in the capital account implies an offsetting rise in the deficit in the U.S. current account most of which is trade in goods and services. As shown in Figure 4, the consensus of 50 forecasters compiled by Blue Chip Economic Indicators is for real net exports of goods and services to decline by about $43 billion from an estimated -$146.3 billion in 1997 to -$189.2 billion in 1998. Prior to the Asian financial crisis, the consensus forecast compiled by Blue Chip Economic Indicators was for the balance of real U. S. exports and imports of goods and services to improve and for the deficit to become smaller in 1998. From July 1997 to January 1998, the consensus forecast for this balance worsened by $63 billion. Standard & Poor's Data Resources, Inc. expects the U.S. merchandise trade deficit (customs value) to increase by $33.5 billion from $182.7 billion in 1997 to $216.2 in 1998 and further to $248.1 billion in 1999. It expects the U.S. deficit on current account likewise to rise by $27.3 billion from $163.8 billion in 1997 to $191.1 billion in 1998 and further to $211.8 billion in 1999. 29 As shown in Figure 5, the United States already runs a deficit in its merchandise trade with the Asian countries that have experienced currency problems - except for South Korea. In most cases, the deficits are estimated to remain high or increase in 1997. Microeconomic Effects On a microeconomic level, the Asian Financial Crisis affects those industries most closely linked to the economies in question. The following provides a rough outline of the major U.S. sectors affected. U.S. creditors and investors in Asia-U.S. banks, pension funds, and investors stand to lose on their precrisis exposures, but "bottom fishers" may gain as Asian equity markets recover and currencies strengthen. U.S. exporters to Asia-U. S. makers of major export items, such as heavy equipment, aircraft,

manufacturing machinery, and agricultural commodities are seeing demand for their products decline. U. S. producers of commodities used in the manufacture of products in Asia also are experiencing soft prices (e.g. chemicals, cotton, copper, and rubber). U.S. businesses that compete with imports from Asia - U. S. manufacturers of automobiles, apparel, consumer electronics, steel, and other products that compete with imports from Asia are likely to see increased competition and downward pressures on prices. Exporters from Korea, however, report that they are experiencing difficulty obtaining foreign exchange to finance imports needed in their production processes. This, in turn, constrains their exports. U. S. labor engaged in manufacturing competing products tend to be hurt by Asian exchange depreciation. U.S. businesses related to interest rates-mortgage bankers, refinancing companies, builders, and other businesses that benefit from lower rates of interest are seeing greater activity. U.S. businesses the sell imports from Asia-distributors and retailers of products from the troubled Asian economies are likely to have increased activity. These include discount retailers and Korean automobile dealers. U.S. multinational corporations seeking market access in Asia-U.S. companies, particularly in the financial sector, that have encountered barriers to entry or restrictions on their activities in Indonesia, Thailand, and South Korea are likely to benefit from the market opening required by the IMF support packages. They also may be able to buy existing firms that need restructuring and recapitalization at relatively low prices. U.S. multinational corporations with manufacturing subsidiaries in Asia -Most U.S. companies with direct investments in the region will probably weather the storm, although some investments (such as the new General Motors plant in Thailand) have been thrown into question. Since about 60% of the output from U.S. manufacturing subsidiaries in Asia is sold in the region, local sales are likely to stagnate until economic growth resumes. Some excess capacity may emerge. For a manufacturing subsidiary in a country with a depreciated local currency, its cost of imported components will tend to rise, but the price of the finished export to the U.S. and other hard currency markets will tend to fall. U.S. industries that use components from Asia-U.S. manufacturers that use parts and other inputs

from Asian countries whose currencies have depreciated are likely to experience lower costs of production. An overall indicator of the effect of the Asian financial crisis on U.S. businesses is the outlook for corporate profits. The increased competition from imports combined with rising wage costs in the United States is expected to reduce the growth in U.S. corporate profits in 1998 to about 4.7% or roughly half the increase in 1997.30 Causes of the Financial Crisis The causes of financial problems in these countries are many and differ somewhat from economy to economy. In general, the Asian Tiger economies had been growing at rates of 5 to 10% per year for the past decade. They were opening their economies to foreign direct investments, foreign goods and services, capital flows, and were relying heavily on dollar markets, particularly the United States, to absorb their exports. In order to attract foreign investments and facilitate capital flows, their currency exchange rates were kept in fairly close alignment with the U.S. dollar or a basket of currencies dominated by the dollar. The financial services sector in most of these newly industrialized economies had been developing rapidly and without sufficient regulation, oversight, and government controls. As capital markets were liberalized, banks in these countries could borrow abroad at relatively low rates of interest and relend the funds domestically. Over the past decade, foreign borrowing by these countries had shifted from a preponderance of government to private sector borrowing. Whereas in the 1970s, the governments might have borrowed for infrastructure development from the World Bank or a consortium of international banks, in the 1990s, a local bank might borrow directly from a large New York money center bank. The financial crisis in Asia began in currency markets, but this exchange rate instability was caused primarily by problems in the banking sectors of the countries in question. The causes and structural factors contributing to the financial crises include: private-sector debt problems and poor loan quality, rising external liabilities for borrowing countries, the close alignment between the local currency and the U. S. dollar, weakening economic performance and balance-of-payments difficulties,

currency speculation, technological changes in financial markets, and a lack of confidence in the ability of the governments in question to resolve their problems successfully. Bank Borrowing and Lending The financial difficulties in Asia stemmed primarily from the questionable borrowing and lending practices of banks and finance companies in the troubled Asian economies. Companies in Asia tend to rely more on bank borrowing to raise capital than on issuing bonds or stock. Governments also have preferred developing financial systems with banks as key players. This is the Japanese model for channeling savings and other funds into production rather than consumption. With bank lending, the government is able to exert much more control over who has access to loans when funds are scarce. As part of their industrial policy, governments have directed funds toward favored industries at low rates of interest while consumers have had to pay higher rates (or could not obtain loans) for purchasing products that the government has considered to be undesirable (such as foreign cars). A weakness of this system is that the business culture in Asia relies heavily on personal relationships. The businesses which are well-connected (both with banks and with the government bureaucracy) tend to have the best access to financing. This leads to excess lending to the companies that are well-connected and who may have bought influence with government officials. For example, Figure 6 outlines the lending system in South Korea. Korean banks and large businesses borrow in international markets at sovereign (national) rates and re-lend the funds to domestic businesses. The government bureaucrats often can direct the lending to favored and well-connected companies. The bureaucrats also write laws regulating businesses, receive approval from the parliament, write the implementing regulations, and then enforce those regulations. They have had great authority in the Korean economic system. The politicians receive legal (and sometimes illegal) contributions from businesses. They approve legislation and use their influence with the bureaucrats to direct scarce capital toward favored companies. 31 International borrowing involves two other types of risk. The first is in the maturity distribution of accounts. The other is whether the debt is private or sovereign. As for maturity distribution, many banks and

businesses in the troubled Asian economies appear to have borrowed short-term for longer-term projects. Many economists blame such loans for the Asian crisis.32 Some of this debt is to finance trade and is selfextinguishing as the trade transactions are completed. Mostly, however, these short-term loans have fallen due before projects are operational or before they are generating enough profits to enable repayments to be made, particularly if they go into real estate development. As long as an economy is growing and not facing particular financial difficulties, rolling over these loans (obtaining new loans as existing ones mature) may not be particularly difficult. Competition among banks is intense. In the Asian case, as U. S. banks began to restrict lending in certain Asian countries in 1996 and 1997, European banks took up much of the slack. When a financial crisis hits, however, loans suddenly become more difficult to procure, and lenders may decline to refinance debts. Private-sector financing virtually evaporates for a time.33 Figure 7 shows the total amount borrowed by selected Asian countries and the distribution of the maturities on those accounts. For the six Asian countries shown, all have relied heavily on debt with a maturity of one year or less. At the end of 1996, the proportion of loans with maturity of one year or less was 62% for Indonesia, 68% for South Korea, 50% for the Philippines, 65% for Thailand, and 84% for Taiwan. A structural change in the nature of the borrowing by these Asian countries is that the type of borrowing has shifted away from the government and banks borrowing from international financial institutions (such as the World Bank) or receiving development assistance funds through foreign aid programs to borrowing by private corporations. Figure 8 shows the distribution of borrowing from banks according to the type of borrower. Until capital markets were liberalized in the newly industrializing countries of Asia, most of the outside funds flowing into these economies was borrowed by the governments (public sector). Now major banks and the non-bank private sector account for most of the borrowing. A problem with private sector borrowing in developing market economies is that while individual borrowers may have viable projects, when all borrowing is aggregated and demands for foreign exchange

and repayment are tallied, the country can face difficulties. It is a type of fallacy of composition. Even if each individual loan is financially viable, the total of all loans may not be so because the nation may be short of the foreign exchange necessary to meet the repayment schedules. Although Japan is not considered to be one of the Asian economies experiencing a currency crisis, it has been experiencing many of the same problems that are confronting its Asian neighbors. Japan's banking sector, for example, carries an estimated $600 billion in questionable and nonperforming loans despite aggressive writeoffs in recent years.34 When world attention began to be focused on Japan's problem of nonperforming 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 more like $400 billion or about 9% of gross national product. Private analysts, however, put the figure at roughly double that amount.35 Since 1992, the top 20 Japanese banks have written off approximately 35 trillion yen (about $290 billion) in bad loans.36 Still, the combination of the weak Japanese stock market, weak real estate values, and sluggish economy continues to threaten Japan' s banks as well as securities companies. Although the currency crisis has not affected mainland China's renminbi to a large extent, China still has the potential of experiencing a major financial crisis. The problem began in 1981 when the government changed the banking system from one in which banks financed investments and provided funds to enterprises as part of the government's central plan to one based more on banking principles. Banks were to provide funds only as loans rather than as investments and were to charge interest and require repayments. Suddenly, the flow of funds from the banks to state-owned enterprises became liabilities that had to be repaid. China's four state-owned specialty banks do 75% of the nation's deposit and loan business. Data on the condition of these banks is sketchy, but in late 1994, the four banks reported over 570 billion yuan (about $68 billion) in bad loans or about 20% of all the loans they had issued. Overdue loans were 11.3%, idle loans 7.7% and uncollectible loans 1.3%. These accounted for 90% of the officially recognized bad loans in the

banking system.37 These figures, however, are likely to be understated because the state-owned banks have been lending to state-owned enterprises, and only about 30% of those enterprises are profitable, 20% have been losing money for years and are beyond salvaging, and the remaining 50% are somewhere in between.38 The state-owned banks, therefore, have accumulated a huge portfolio of bad debts that have little prospect of being repaid. As was pointed out at a conference in Beijing in January 1997, China's national economy is being threatened by a latent monetary credit crisis. Furthermore, even though loans now are supposed to be allocated according to sound banking principles, in practice a large amount of monetary assets is still being allocated ineffciently through administrative and planned economic channels. State-owned banks have been required to provide loans to support enterprises which are running at low profit rates or at a loss. These are "loans for preservation of stability and unity" and "loans for clearing up defaults." The resultant depletion of assets of state-owned banks has become an important factor threatening their own survival.39 Bank Exposure How exposed are the banks of the major industrial countries to borrowers in these Asian economies? Table 2 shows the international claims (loans) of all reporting banks in the United States, United Kingdom, Germany, Japan, and the world with respect to selected Asian countries involved in the financial crisis. Bank lending data pose a particular problem because of offshore banking centers, such as Aruba, the Bahamas, Hong Kong, and Singapore. Often the banks in these centers simply provide a conduit for funds that ultimately are used outside the center. Table 2, therefore, shows two sets of totals: one for countries and one for offshore banking centers. (The two sets of data are not completely compatible.) At the end of 1996, the U.S. banks reported $29.1 billion in loans outstanding to Indonesia, South Korea, Malaysia, the Philippines, Taiwan, and Thailand. There was an additional $14.4 billion loaned to Hong Kong and Singapore for a total of $57.9 billion. This amounted to 34.9% of all U.S. international lending (including offshore banking centers). The greatest U.S. exposure was in Hong Kong and South Korea. As for other major lending countries the United Kingdom reported 50.8% of its loans to these eight Asian

economies and Germany 33.6%. Table 2. International Claims (Loans) by Banks in Selected Developed Nations on Borrowers in Troubled Asian Economies December 31, 1996 ($Millions) Claims on byU.S. U K. Germany Japan World Indonesia 5,279 3,834 5,508 22,035 55,523 South Korea 9,355 5,643 9,977 24,324 99,953 Malaysia 2,337 1,417 3,857 8,210 22,231 Philippines 3,902 1,173 1,820 1,558 13,289 Taiwan 3,182 2,773 2,628 2,683 22,363 Thailand 5,049 3,128 6,914 37,525 70,181 Total Above Asia 29,104 17,968 30,704 96,335 283,540 Asian Offshore Banking Centers Hong Kong 8,665 26,216 26,811 87,462 207,164 Singapore 5,727 22,523 40,767 58,809 189,310 Total Asian Offshore 4,392 48,739 67,578 146,271 396,474 Total Asia + Asian 57,888 66,707 98,282 242,606 680,014 Offshore Centers Total World 130,053 68,325 173,101 169,699 993,134 Total Offshore 35,617 63,024 119,170 219,690 663,897 Banking Centers Total World + 165,670 131,349 292,271 389,389 1,657,031 Offshore Centers Asia as % of World 34.9 50.8 33.6 62.3 41.0 (Including Offshore Banking Centers) Note: Data are for lending which is outside of the home market (does not include domestic lending). Data from offshore banking centers are not completely compatible with BIS reporting country data. Source: Bank for International Settlements. The Maturity, Sectoral and Nationality Distribution of International Bank Lending. Second Half 1996. Basle, Switzerland, July 1997. P. 19-20. Japan's bank exposure was particularly high. It reported 62.3% of its international lending to these Asian countries. In the offshore centers, Japan reported $87.5 billion in Hong Kong and $58.8 billion in Singapore. For Thailand, Japan reported $37.5 billion in claims, and more than $20 billion each in Indonesia and South Korea. The U. S. Federal Financial Institutions Examination Council provides more recent data that those available through the Bank for International Settlements (BIS) used above. BIS data also have been adjusted somewhat to eliminate double counting and to be consistent across reporting nations. The Council data indicate that U.S. bank claims in these Asian economies declined after December 1996 from $45.2 billion for

these eight Asian economies to $41.9 billion as of June 30, 1997. This amounted to 0.2% of total U.S. banking assets of $2,552.5 billion and 1.5% of total banking capital of $272.8 billion.40 It appears that U.S. banks had become aware of the increasingly risky loan environment in Asia and in 1997 had been reducing exposure accordingly. U.S. banks do not seem to be excessively exposed to the Asian economies suffering from currency weaknesses. This is a vastly different picture than was presented at the onset of the Latin American debt crisis in August 1982. In December 1982, U.S. banks were owed $24.4 billion by Mexico alone. This amounted to 34.6% of their total capital and about 2.0% of their total assets. 41 In addition to dollar-denominated claims, the U. S . Federal Financial Institutions Council also reported that U. S. banks have claims for loans in local currencies that do not appear in BIS statistics. As of June 30, 1997, these loans amounted to $1,403 million in Hong Kong, $74 million in Indonesia, $1,150 million in Malaysia, $1,567 million in Philippines, $1,288 million in Singapore, $1,363 million in Taiwan, and $2,023 million in Thailand. Pegged Exchange Rates The structural factor that initially enabled the crisis to occur was that the exchange rates of most of these currencies had been aligned with the dollar or a basket of currencies dominated by the dollar. These pegged exchange values had not been allowed to adjust sufficiently in response to changing economic conditions. Governments allowed their exchange rates to fluctuate only within narrow bands. The advantage of this system to the countries involved was that it kept the countries' exchange rates relatively constant with respect to the dollar and allowed their traders to import from and export to dollar areas, particularly the United States, with little exchange rate risk. It also provided a stable financial environment that encouraged foreign sources of capital for loans or investments. The Thai monetary authorities, for example, had pursued a "stable baht" policy that had kept the official rate for their currency at about 25 baht per dollar since 1987. This linking of official exchange rates to the dollar, however, had one major drawback. As the value of the dollar changed, so did the value of these currencies relative to others,

such as the Japanese yen and German mark, that were not tied to the U.S. dollar. As the dollar depreciated after 1985, the arrangement worked reasonably well, even though macroeconomic conditions in these countries differed widely from those in the United States (particularly, rates of inflation and growth). Problems began to arise in 1996 and 1997, however, as the dollar appreciated and the official values of these currencies deviated from their underlying market values. While the dollar was pulling up the value of these currencies, some of the countries in question encountered increasing difficulty in balancing their international accounts. Their exports grew more costly to non-dollar buyers, and their imports from nondollar areas cheaper. The weak yen, in particular, was reducing the competitiveness of their products relative to those from Japan. The consequent rising deficits in their trade and current accounts placed downward pressure on their exchange rates which required more and more government intervention to maintain. When downward pressures on a currency occur in foreign exchange markets, if the exchange rate is allowed to adjust freely, an initial depreciation tends to lessen pressures for more depreciation. The rewards for speculating in the market (by betting on a future depreciation) diminish. With an exchange rate tied to the dollar, however, government attempts to maintain the rate often raise the expectations of traders that the currency is headed for a fall. This places even more downward pressure on the currency as traders rush to sell it in anticipation that they will be able to buy it later at a lower price. If the governments involved do not have sufficient foreign exchange reserves to stave off the speculators and others in the market, they eventually have to concede failure and allow the currency to depreciate. When that process begins, the fall in the currency may be quite dramatic and may overshoot the equilibrium rate. Currency depreciation, in turn, places an additional burden on local borrowers whose debts are denominated in dollars. They now are faced with debt service costs that have risen in proportion to the currency depreciation. These debtors respond to the weakening currency by attempting to hedge external liabilities which intensifies exchange rate and interest rate pressures.42 In the South Korean case, for

example, the drop in the value of the won from 886 to 1,701 won per dollar between July 2 and December 31, 1997, nearly doubled the repayment bill when calculated in won for Korea's foreign debts. The depreciated local currency, however, makes exports from the country cheaper and more competitive in foreign markets. Nominal exchange rates also may change in response to differing rates of inflation among countries. A high inflation rate will cause a nation's currency to depreciate, but the real exchange rate (adjusted for inflation) may remain the same. In some of the Asian countries with currency problems, inflation rates have been higher than those in the United States. Still a depreciation of 20 or 30% far exceeds inflation rates in 1997 of about 3% in Malaysia and Taiwan, 5% in South Korea, and 7% in Indonesia, the Philippines, and Thailand. As the Asian financial crisis has progressed, the affected governments (except for Hong Kong) have eased the rigidity of their exchange rate systems. Exchange rates now are allowed to move in wider bands, in a crawling band, or are floating. This flexibility reduces the potential for large and sudden changes in these exchange values, as the rates respond continuously and in smaller increments to market forces. Government exchange rate policy suffers from a common policy dilemma. If a country targets its monetary and fiscal policy toward maintaining a specific exchange rate, it must sacrifice performance in its domestic economy. A government defending its exchange rate, for example, usually has to raise interest rates in order to attract capital into its economy. This tends to dampen its growth rate. Government policymakers do not have policy tools that enable them to target both an exchange rate and economic growth rate. With respect to pegged exchange rates, however, there is an alternative school of thought that currency values should be pegged to gold or some other standard of value and kept stable.43 Those who view exchange rates in these terms may see the cause of the currency crises in the Asian countries as excessive expansion of domestic money supplies by central banks combined with burdensome government regulations, protection of domestic industries, and other government interference in the marketplace.44 Once governments stopped maintaining their exchange rates, investors lost confidence, and the crises began. Economic Growth

Most of the countries in Asia that now are encountering currency problems had logged remarkably high economic growth rates over the past decade. These high rates of growth brought higher standards of living but also brought problems. To one degree or another, most of these countries have been facing difficulties with their balance of payments, over-expansion of production capacity, rising real estate values, overvalued equities, and excessive bank lending. As of first quarter 1997 before the crisis began, the growth rates for these Asian countries had remained quite high, and the outlook was generally favorable. Any dramatic slowdown in growth had not yet appeared in their short-term outlook. As shown in Figure 9, economic growth rates over the past decade for four countries involved in the first round of currency problems. The forecast for 1997 is as of the first quarter, before the currency crisis began. As can be seen, growth was slowing but still remained at remarkably high rates and was expected to continue in 1997. Thailand's economic growth rate had fallen from 13% in 1988 to 6.5% in 1996. In 1997, however, it was expected to recover from its downward slide. The effect of a slowdown in growth on a nation's exchange rate is not immediately obvious. It affects both trade and capital accounts in opposite ways. On one hand, lower growth usually causes a nation's trade balance to improve, since imports decline relative to exports (unless demand in export markets is falling faster). This could strengthen a nation's currency. In the Asian case, however, growth was continuing at a level high enough that trade and current accounts tended to remain in deficit. Even in Thailand, the slowdown had not improved its balance of trade. On the capital account side, a slowing growth rate generally causes problems for a nation's debtors who have borrowed to finance production facilities or have invested in real estate or equities and are faced with repayment schedules. Lower growth means lower demand, possible lower profits, and a leveling off or fall in real estate and stock values. As the slowdown intensifies, interest rates usually fall. This can cause international lenders to look elsewhere for investment for financing opportunities and may cause a weakening of a nation's currency. Recessions also cause loans to turn sour and may further drive away foreign lenders. As the Asian financial crisis has developed, forecasters have lowered their outlook

for growth in these countries. The securities firm, J.P. Morgan, for example, lowered its forecast for economic growth for ASEAN (Indonesia, Malaysia, Singapore, Thailand, Philippines, Brunei, and Vietnam) for 1998 from 5.9% in June 1997 (before the crisis began) to 2.2% in November 1997.45 Forecasters expect economic growth in South Korea to drop from 5.9% in 1997 to around -1.5% in 1998.46 Current Account Imbalances The high growth rates among the Asian countries had begun to create problems for them in balancing their current and trade accounts. The current account is a nation's balance of trade in imports and exports plus net income from foreign investments, and unilateral transfers. It consists of the payments for goods and services, interest and dividends, and remittances by foreign workers to their home countries. Figure 10 shows current account balances for four of the Asian nations that have had to depreciate their currencies. (Comparable data for Malaysia were not available from the IMF.) In the case of Thailand, its deficit in its current account had been widening from 1992. In 1996, the deficit had grown to $14.7 billion for the year. As a percent of gross domestic product, this deficit had reached 8%. The IMF considers that when current account deficits reach 5 to 8% of GDP, they merit close monitoring. 47 This deficit was the primary reason for the downward pressure on the baht. By the time Thai authorities tightened economic policies, investorsboth foreign and domestic-were pulling funds out of the country, and the currency crisis had already developed. South Korea's current account deficit also worsened considerably in 1996. For the year, it was $23.1 billion. The current account deficit for the Philippines, on the other hand, had shrunk somewhat. Capital Flows The primary reason that the deteriorating current account balance for these nations had not placed severe downward pressures on their exchange rates earlier was that foreign capital was flowing in from other countries. Foreign investors, businesses establishing manufacturing subsidiaries, international banks lending to local borrowers, and others were providing a steady stream of foreign exchange and a positive balance on

financial account. This tended to offset the current account deficits. As shown in Figure 11, in 1996, South Korea ran a surplus in its financial account of $24.0 billion that completely offset its deficit of $23.1 billion in its current account. Much of the surplus in Korea's financial account came from portfolio investments. In 1996, while Koreans invested $2.4 billion in foreign equity and debt securities, foreigners invested $16.8 billion in Korea securities. Portfolio investments can be volatile. Funds can flow out as fast as they flow in. In October 1997, for example, as trouble developed in the Hong Kong and other stock markets, investors began to flee Korean equity markets. Over the weekend of October 25 following the fall in the Hong Kong stock market, foreign investors sold 20.1 billion won ($22 million) worth of Korean stocks. This started a rush out of Korean securities that sent the composite index of stock values on the Seoul exchange to a ten year low of 450.6 on November 24, 1997, down 30% for the year. The experience of the Asian newly industrializing countries reflects a major structural change in international capital markets that has occurred over the past decade. This has been the liberalization of capital flows into and out of most emerging market economies. Borrowers and investors are able to bypass governments and local financial institutions and seek funds from a variety of world sources. Private capital in the form of bank lending, direct investments, and portfolio investments has flowed into these economies. Whereas a decade ago, most capital inflows into emerging markets were from official sources, now private investment flows far exceed official development assistance or other government-based finance. According to the U.S. Treasury, on a worldwide basis, capital flows into emerging market economies rose from $25 billion in 1986 to $250 billion in 1996. Between 1990 and 1996, the share of crossborder portfolio flows accounted for by these emerging markets rose from 2% to 30 /O, while their share of global foreign direct investment jumped from 15% to 40% 48 For South Korea, for example, aggregate foreign investment inflows (both portfolio and direct investment) from January 1962 to April 1997 totaled $21.6 billion. Of this amount, $5.6 billion came from Japan, $6.7 billion from the United States, $5.3 billion from the European Union, $3.6 billion from other sources.49

According to Alan Greenspan, Chairman of the U.S. Federal Reserve, "In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk."50 One impetus behind these flows was the run up in the U.S. stock market and the desire of investors to diversify their holdings. Much of the direct investment went toward building production capacity -some of which may be unused as these economies slow. Weak Governmental Institutions The rapidity with which the Asian economies have grown and liberalized their financial markets has meant that the development of the financial systems in some economies has not kept pace with development of the financial markets. To varying degrees, there have been lax lending standards, weak supervisory regimes, inadequate capitalization, excessive inter-connected lending, and a more general lack of a credit culture.51 Safety nets such as deposit insurance has been lacking in some countries. Problems have developed, and governments often have hid the true extent of those troubles. One concern has been lack of skilled manpower. Analysts point out that as private banks and other financial institutions have developed in these Asian tiger economies, they frequently have gone to government bureaucracies and hired away officials with the skills and experience necessary to run their companies. Foreign banks, in particular, have been faced with the dual problem of not having the skilled personnel necessary for their operations and needing someone on staff who is familiar with the bureaucracy and has the connections necessary to work with government officials. An important source of such personnel has been the government finance ministries and other agencies. This exodus of skilled officials in some of the countries exacerbated the problem of regulating the rapidly developing financial sectors. Speculation The role of currency speculation in the 1997 Asian currency crisis has been sharply debated. Malaysian Prime Minister Mahathir has blamed large foreign investment funds, particularly hedge fund manager George Soros, for attacks in the marketplace on the Malaysian ringgit and other currencies in order to generate profits for themselves without regard to the livelihood of the Malaysian or other local people. At a

meeting of the International Monetary Fund in Hong Kong on September 20, 1997, Mahathir said that currency trading (other than to finance trade) was immoral and should be stopped. He castigated the traders as being responsible for the drop in the ringgit and the resultant loss in (dollar-denominated) per capita income in Malaysia.52 Given recent trends toward liberalizing flows of goods and capital among nations and progress in telecommunications and electronic trading, opportunities for speculation in currencies have proliferated. Even though foreign exchange markets originally developed primarily to serve importers and exporters, the vast majority (more than 95%) of current transactions in these markets is for capital transactions. These transactions are done by companies, investors, fund managers, speculators, and others who are moving in and out of foreign currencies for reasons not directly related to international trade. These capital transactions are determined by underlying monetary policies, expectations, investment opportunities, and government regulations. The mammoth size of world exchange markets make them virtually impossible for governments to control, or for most, to influence significantly. When governments do intervene, they have discovered that they can only "lean against the wind" (they can slow down movements in exchange markets but rarely can change their direction). Central banks, such as the Bank of Thailand and Bank of Korea, have drawn their foreign exchange reserves down to perilous levels by trying to maintain their exchange rates. Still speculators say that they only exploit gaps between actual and potential exchange rates. These gaps arise because of changes in market expectations as well as the underlying fundamentals of an economy. The U.S. Treasury maintains that short-term speculative flows were not the major source of the pressures on governments that caused the Asian financial crisis.53 Financial Market Technology Changes in the technology of financial markets have occurred both in the types of financial instruments available and in the integration of financial markets world wide. Combined with the spread of electronic fund transfers, telecommunications, and the Internet, funds now are able to flow from one country to another quickly and in large quantities. This has increased the speed and extent to which disturbances in one market can affect another. As one economist put it in the fall of 1997, six months ago, no one

would have expected real estate loan defaults in Thailand to raise interest rates in Estonia.54 Few also would have expected a drop in the Hong Kong market to trigger a run on stocks on Wall Street. The U.S. Federal Reserve stated that the contagion effect of weakness in one economy spreading to others has been troublesome to them. If one economy has a problem, investors search for other economies that might have similar vulnerabilities. The resultant pressures on exchange rates or drops in stock values may or may not be warranted by economic fundamentals. Even Hong Kong with its ample stocks of foreign reserves, balanced external accounts, and relatively robust financial system was not immune from such pressures.55 Issues for Congress The U.S. Congress is likely to consider the Asian financial crisis within three broad legislative contexts. The first is in the financing and scope of the activities of the IMF and other international financial institutions. The second is in the impact of the crisis on the U.S. economy and American financial institutions, and the third is in efforts to liberalize trade and investment in the world. The primary legislative issues revolve around the International Monetary Fund. The most important of these is a request for an increase in the U. S . capital contribution to the IMF, that is, in its so-called "quota."56 Quotas provide the IMF with the financial resources from which it extends loans to economically troubled countries. In addition to determining the size of the IMF's capital and member's contributions, quotas also determine a member country's voting power, its access to IMF loans, and its share in any allocation of Special Drawing Rights (SDRs). Quotas, therefore, are fundamental to the IMF's operation.57 On September 21, 1997, the Interim Committee of the IMF announced an agreement to increase overall IMF quotas by 45%. This was finalized in late December 1997 and adopted on February 6, 1998. Total IMF quotas would increase from about SDR 146 billion (about $197 billion, as of April 9, 1998) to SDR 212 billion ($287 billion). The U.S. quota would increase by 40%, from SDR 26.5 billion ($35.8 billion) to SDR 37.1 billion ($50.2 billion), an increase of about $14.4 billion. At the same time, the U.S. share of total IMF quotas would drop from 18.1% to 17.5%. The United States would retain its veto on important IMF decisions,

including any decision to increase quotas, allocate SDRs, or amend the IMF's Articles of Agreement. The United States would also continue to be the IMF's largest shareholder, a position that gives it considerable voice in the decisions and operations of the IMF. Historically, requests for the approval of an increase in the U.S. quota have always been the occasion for vigorous Congressional examination of the programs and policies of the IMF and oversight of the U. S. role there. The current financial crisis in Asia, with its spillover-effects on the U. S. economy and financial markets, is likely to heighten the rigor of congressional oversight, particularly with regard to the IMF's conditionality, its emergency financing mechanisms, and its surveillance and data dissemination procedures. In addition to the request for approval of U. S. participation in the quota increase, Congress will be asked to reconsider and approve the "New Arrangements to Borrow" (NAB).58 The NAB are an arrangement of medium-term credit lines that the IMF may borrow against to supplement its resources in the event of an international financial crisis. They were proposed in the wake of the 1994 Mexican peso crisis. Commitments to the NAB from 25 participant amount to SDR 34 billion, currently about $46 billion. The U.S. share in the NAB totals SDR 6,712 ($9.0 billion), including SDR 4,250 million ($5.7 billion) that was authorized and appropriated prior to 1983 for U.S. participation in the "General Arrangements to Borrow" (GAB).59 Because of this earlier funding, only the incremental amount of SDR 2,462 million (currently $3.3 billion) need be approved for the United States to fulfill its NAB commitment. This issue was considered during the first session of the 105th Congress. In the midst of a controversy over abortion funding, however, provisions related to the NAB were stripped from the foreign operations appropriation for 1998 (P.L. 105-118). Under the Bretton Woods Agreements Act (P.L. 79-171, 22 USC 286), both the increase in the U.S. quota in the IMF and U.S. participation in the NAB must be authorized by the U.S. Congress. In addition, current U.S. budgetary treatment requires that both be appropriated.60 The current financial crisis, ultimately, is also likely to connect with a number of other proposed issues

related to the IMF. These include a proposed allocation of SDRs6' and a proposed amendment to the IMF's Articles of Agreement. The former would help to ease reserve constraints experienced by many IMF members. The latter, whose language has not yet been agreed, would provide the IMF with a mandate to foster capital account liberalization. The rising U.S. trade deficit combined with heightened competition from imports from countries with depreciated currencies may intensify political pressures to protect U. S. industries from foreign competition. Initiatives to liberalize imports or provide fast-track negotiating authority to the President may face higher hurdles. U. S .lending institutions that are highly exposed to the Asian financial problems also could develop problems of their own. The Asian financial crisis also could put a damper on negotiations to liberalize trade and investment in Asian markets. Some of the countries affected have been reluctant to proceed with more trade and investment liberalization until they are able to regroup and recover from their current problems. FOOTNOTES: 1 Asia Pacific Economic Cooperation. APEC 97 Leaders Declaration. November 25, 1997. 2 Associate Press. Asian Officials Establish Supplementary Bailout Fund. AP Newswire. December 2, 1997. 3 ASEAN. Joint Statement of the Heads of State/Government of the Member States of ASEAN on the Financial Situation. December 15, 1997. Available on the Internet at . 4 Boorman, Jack. The Changing Emphasis of the Fund, Implications for Stabilization and Growth Policies. Paper presented at the IMF Seminar, Asia and the IMF. September 19, 1997. Hong Kong. 5 These questions are discussed in more detail in CRS Report 98-56, The International Monetary Fund 's (IMF) Proposed Quota Increase: Issues for Congress, by Patricia A. Wertman. 6 Boorman, Jack. The Changing Emphasis of the Fund, Implications for Stabilization and Growth Policies. Paper presented at the IMF Seminar, Asia and the IMF. September 19, 1997. Hong Kong. 7 South China Morning Post, January 8, 1998. P. 3. 8 Davis, Bob and David Wessel. World Bank IMF at Odds over Asian Austerity. Wall Street Journal, January 8, 1998. P. A5, A6. 9 See, for example, Sachs, Jeffrey. Power Unto Itself. Financial Times, December 11, 1997. P. 11. 10 The "Special Drawing Right" or SDR is an international reserve asset created by the IMF and used to

denominate its accounts. In mid-1997 one SDR was worth $1.36. 1l International Monetary Fund. IMF Approves Stand-by Credit for Thailand. Press Release No. 97/37, August 20, 1997. 12 International Monetary Fund. IMF Approves Stand-by Credit for Indonesia. Press Release No. 97/50, November 5, 1997. 13 Sen, Siow Li. Singapore-Indonesia Deal to Support Rupiah Confirmed. Singapore Business Times (Internet edition), November 27, 1997. 14 As of December 1997, the United States had assets equivalent to about $30 billion, excluding SDRs and accounts receivable, in its Exchange Stabilization Fund (ESF). This was about 22% less than ESF assets of $38.2 billion as of December 31, 1994, at the onset of the Mexican Peso crisis. Mexico drew a total of $12.0 billion in short- and medium-term swaps from the ESF. Mexico also drew $1.5 billion in shortterm swaps under lines of credit with the U.S. Federal Reserve. If activated, the standby credit line for Indonesia of $3.0 billion would equal about 10.1% of ESF assets at the end of March 1997. For background on the Exchange Stabilization Fund, see: CRS Report 95-262, The Exchange Stabilization Fund, by Arlene Wilson. 15 Summers, Lawrence, Testimony on the Asian Financial Crisis, November 13, 1997. 16 International Monetary Fund. IMF Approves SDR 15.5 Billion Stand-By Credit for Korea. Press Release No. 97/55, December 4, 1997. Reuters. Korean IMF Bailout. Reuters Newswire. December 3, 1997. Yoo, Cheong-mo. Korea, IMF Agree on Terms, Including Foreign M&A of Korean Firms, Ownership Limit Rise. Korea Herald, December 4, 1997. On Internet at . Note: A special drawing right (SDR) had a value of about 1.4 dollars. 17 Korea Bailout Conditioned On Structural Reforms. DowJones Newswire. December 3, 1997. 18 IMF, IMF Approves SDR 15.5 Billion Stand-By Credit for South Korea. 19 Summers, Lawrence, Testimony on the Asian Financial Crisis, November 13, 1997. 20 Statements by Representatives Barney Frank and Bernard Sanders at the House Banking Committee hearing on the Asian Financial Crisis, November 13, 1997 and January 30, 1998, and January 30, 1998. 21 International Monetary Fund. IMF Bail Outs: Truth and Fiction. January 1998. Available on the Internet at: .

23 U.S. Federal Reserve Board. Testimony of Chairman Alan Greenspan before the Committee on Banking and Financial Services, U.S. House of Representatives, January 30, 1998. Available on the Internet at . 24 Citicorp. Fourth Quarter Report. January 20, 1998. P. 1. 25 Bank of America. BanlcAmerica Fourth Quarter 1997 Earnings. January 21, 1998. P. 15. 24 Citicorp. Fourth Quarter Report. January 20, 1998. P. 1. 25 BankofAmerica. BanlcAmerica Fourth Quarter 1997 Earnings. January 21, 1998. P. 15. 26 J.P. Morgan. Fourth Quarter and 1997 Full Year Results. January 1998. P. 4. Available on Internet at . 27 Blue Chip Economic Indicators. January 10, 1998. 28 Trade in goods and services plus income from foreign investments and unilateral transfers. 29 Standard & Poor's DRl. Review of the U.S. Economy, January 1998. P. i. 30 Blue Chip Economic Indicators, January 10, 1998. 31 For further information on South Korea, see: CRS Report 98-13 E, South Korea's Economy and 1997 Financial Crisis, by Dick K. Nanto. 32 Uchitelle, Louis. Economists Blame Short-term Loans for Asian Crisis. New York Times on the Web. January 8, 1998. At 33 Fischer, Stanley. How to Avoid International Financial Crises and the Role of the International Monetary Fund. Speech given in Washington, DC, October 14, 1997. 34 See: CRS Report 96-837, Japan 's Banking "Crisis ": Bad Loans, Bankruptcy, and Illegal Activity, by Dick K. Nanto. Unrecoverable Loans Held by Banks Reaches Y79 Trillion. Nihon Keizai Shimbun, December 6, 1997 (morning edition). P. 1. 35 CRS Report 95-1034 E, Japan 's Banking Crisis: Causes and Probable Effects, by Dick K. Nanto. 36 Bad Loan Write-offs by Major Banks Total 35 Trillion Yen. Kyodo Newswire article. September 21, 1997. 37 He, Dexu. Key Financial Reform Goals. Jinrong Shibao. November 2, 1993. 38 Sun, Shuangrui. Subordinate Specialized Bank Commercialization to Enterprise Reform (In Chinese). Beijing Caimao Jingji, March 11, 1996. P. 7-13. 39 Xiong, Tang. Pool Collective Wisdom and Efforts to Explore New Ideas on Bank and Enterprise Reform-A Roundup of the Conference on the Strategy for Coordination of the Reforms of State-owned Enterprise and Bank Systems (in Chinese). Beijing Jinrong Shibao, January 5, 1997. p.3. 40 U.S. Federal Financial Institutions Examination Council. Country Exposure Lending Survey.

June 1997. 41 U.S. Federal Financial Institutions Examination Council. Country Exposure Lending Survey. December 1982. 42 Camdessus, Michel. Lessons from Southeast Asia. Press briefing in Singapore, November 13, 1997. 43 See, for example, Kemmerer, Donald L. Why a Gold Standard and Why Still a Controversy. Committee for Monetary Research and Education. 1979. Available on the Internet at . 44 Johnson, Bryan T. and John Sweeney. Down the Drain: Why the IMF Bailout in Asia Is Wasteful and Won't Work. The Heritage Foundation Roe Backgrounder No. 1150, December 5, 1997. 45 JP Morgan. Global Data Watch. November 7, 1997. P. 1. 46 Standard and Poor's Data Resources, Inc. and (Korean) Economic Research Institute. On Internet at 47 Sugisaki, Shigemitsu. The Global Financial System: Status Report. Address at the 11th Conference of the International Federation of Business Economists, Vancouver, Canada. November 18, 1997. 48 Summers, Lawrence. Testimony on the Asian Financial Crisis before the House Committee on Banking and Financial Services. November 13, 1997. 49 The Economist Intelligence Unit. Country Report, South Korea, North Korea. Third Quarter 1997. P. 32. 50 Greenspan, Alan. Testimony on the Asian Financial Crisis before the House Committee on Banking and Financial Services. November 13, 1997. 51 Summers, Larry, Testimony on Asian Financial Crisis. 52 Mahathir, Mohamad. Asian Economies: Challenges and Opportunities. Speech given at the World Bank Group - International Monetary Fund Annual Meetings. September 20,1997. Hong Kong. 53 Summers, Lawrence, Testimony on the Asian Financial Crisis. 54 Hale, David. Seminar on the Asian financial crisis sponsored by the Economic Strategy Institute. November 5, 1997. 55 Greenspan, Alan, Testimony on Asian Financial Crisis, November 13, 1997. 56 Additional information on the proposed quota increase may be found in, U.S . Library of Congress. Congressional Research Service. The International Monetary Fund 's (IMF) Proposed Quota Increase: Issues for Congress, CRS Report 98-56 E, by Patricia A.Wertman. 57 This section was prepared primarily by Patricia A. Wertman, Specialist in International Trade and Finance, Economics Division. 58 For more details on the NAB, see U. S . Library of Congress. Congressional Research Service. The

International Monetary Fund 's "New Arrangements to Borrow " (NAB), CRS Issue Brief 97038, by Patricia A. Wertman. Updated regularly. 59 Additional information on the GAB may be found in, U.S. Library of Congress. Congressional Research Service. The IMF's General Arrangements to Borrow (GAB): A Background Paper, CRS Report 97-467, by Patricia A. Wertman. 60 More details on U.S. budgetary treatment of the IMF may be found in, U. S . Library of Congress. Congressional Research Service. U.S. Budgetary Treatment of the International Monetary Fund. CRS Report 96-279 E, by Patricia A. Wertman. 61 On September 21, 1997, the Interim Committee of the Board of Governors of the IMF announced agreement on a one-time, targeted special allocation of SDR 21.4 billion(currently about $29.0 billion). This proposal would require congressional authorization, but no appropriation. For more information on the allocation of SDRs, see U.S. Library of Congress. Congressional Research Service. The IMF's Proposed Special Drawing Rights' (SDRs) Allocation: A Background Paper, CRS Report 97-738 E, by Patricia A. Wertrnan. APPENDIX Table A1. Exchange Rates for Selected Asian Economies, 1997-98 Date Indonesian Malaysian Philippine Thai Hong Kong Japanese South Korean Singaporean Taiwan Rupiah Ringgit Peso Baht Dollar Yen Won Dollar Dollar Jan 3 2,362.9 2.52 26.25 25.7 7.74 116.32 841.3 1.40 27.48 Jan 31 2,371.2 2.49 26.33 25.9 7.75 121.20 863.1 1.41 27.42 Feb 28 2,391.4 2.48 26

The Asian

Financial Crisis Charles W.L.Hill University of Washington Asian Contagion Between June 1997 and January 1998 a financial crisis swept like a brush fire through the "tiger economies" of SE Asian. Over the previous decade the SE Asian states of Thailand, Malaysia, Singapore, Indonesia, Hong Kong, and South Korea, had registered some of the most impressive economic growth rates in the world. Their economies had expanded by 6% to 9% per annum compounded, as measured by Gross Domestic Product. This Asian miracle, however, appeared to come to an abrupt end in late 1997 when in one country after another, local stock markets and currency markets imploded. When the dust started to settle in January 1998 the stock markets in many of these states had lost over 70% of their value, their currencies had depreciated against the US dollar by a similar amount, and the once proud leaders of these nations had been forced to go cap in hand to the International Monetary Fund (IMF) to beg for a massive financial assistance. This section explains why this happen, and explores the possible consequences, both for the world economy, and for international businesses? Background The seeds of the 1997-98 Asian

financial crisis were sown during the previous decade when these countries were experiencing unprecedented economic growth. Although there were and remain important differences between the individual countries, a number of elements were common too most. Exports had long been the engine of economic growth in these countries. A combination of inexpensive and relatively well educated labor, export oriented economies, falling barriers to international trade, and in some cases such as Malaysia, heavy inward investment by foreign companies, had combined during the previous quarter of a century to transform many Asian states into export powerhouses . Over the 1990-1996 period, for example, the value of exports from Malaysia had grown by 18% per year, Thai exports had grown by 16% per year, Singapores by 15% per year, Hong Kongs by 14% per year, and those of South Korea and Indonesia by 12% per year. The nature of these exports had also shifted in recent years from basic materials and products such as textiles to complex and increasingly high technology products, such as automobiles, semi-conductors, and consumer electronics. An Investment Boom. The wealth created by export led growth helped to fuel an investment boom

in commercial and residential property, industrial assets, and infra-structure . The value of commercial and residential real estate in cities such as Hong Kong and Bangkok started to soar. In turn, this fed a building boom the likes of which had never been seen before in Asia. Office and apartment building were going up all over the region. Heavy borrowing from banks financed much of this construction, but so long as the value of property continued to rise, the banks were more than happy to lend. As for industrial assets , the continued success of Asian exporters encouraged them to make ever bolder investments in industrial capacity. This was exemplified most clearly by South Koreas giant diversified conglomerates, or chaebol , many of which had ambitions to build up a major position in the global automobile and semi-conductor industries. An added factor behind the investment boom in most SE Asian economies was the government. In many cases the government had embarked upon huge infra-structure projects. In Malaysia, for example, a new government administrative center was been constructed in Putrajaya for M $20 billion (US$8 billion at the pre July 1997 exchange rate), the government was funding the development of a massive high technology

communications corridor, and the huge Bakun dam, which at a cost of M$13.6 billion was to be the most expensive power generation scheme in the country. Throughout the region governments also encouraged private businesses to invest in certain sectors of the economy in accordance with "national goals" and "industrialization strategy". In South Korea, long a country where the government played a pro-active role in private sector investments, President Kim Young-Sam urged the chaebol to invest in new factories. Mr. Kim, a populist politician, took office in 1993 during a mild recession, and promised to boost economic growth by encouraging investment in export oriented industries. Korea did enjoyed an investment led economic boom in the 1994-95 period, but at a cost. The chaebol , always reliant on heavy borrowings, built up massive debts that were equivalent, on average, to four times their equity. In Malaysia, the government had encouraged strategic investments in the semiconductor and automobile industries, "in accordance with the Korean model". One result of this was the national automobile manufacturer, Perusahaan Otomobil Nasional Bhd, which was established in 1984. Protected by a 200% import tariff and with few other

competitors, the Proton, as the car was dubbed, sold well in its captive market. By 1989 Perusahaan Otomobil Nasional Bhd was selling 72,000 cars out of a total market of 117,000. By 1995 it had a 62% share of a market which had grown to 225,000 cars annually. Whether this company could succeed in a competitive marketplace, however, was another question. Skeptical analysis note that in 1987 an average 1,600cc Proton cost about three times per capita income in Malaysia; by 1996 a 1,6000cc Proton costs 5.5 times per capita income hardly what one would expect from an efficient enterprise. In Indonesia, President Suharato has long supported investments in a network of an estimated 300 businesses that are owned by his family and friends in a system known as "crony capitalism". Many of these businesses have been granted lucrative monopolies by the President. For example, in 1990 one the Presidents youngest son, Mr Hutomo, was granted a monopoly on the sale of cloves, which are mixed with tobacco in the cigarettes preferred by 9 out of 10 smokers in Indonesia. In another example, in 1995 Suharato announced that he had decided to build a national car, and that the car would be built by a company owned by Mr Hutomo, in association with Kia motors of South Korea. To

support the venture, a consortium of Indonesian banks was "ordered" by the Government to offer almost $700 million in start-up loans to the company. In sum, by the mid 1990s SE Asia was in the grips of an unprecedented investment boom, much of it financed with borrowed money . Between 1990 and 1995 gross domestic investment grew by 16.3% per annum in Indonesia, 16% per annum in Malaysia, 15.3% in Thailand, and 7.2% per annum in South Korea. By comparison, investment grew by 4.1% per annum over the same period in the US, and 0.8% per annum in all high income economies. Moreover, the rate of investment accelerated in 1996. In Malaysia, for example, spending on investment accounted for a remarkable 43% of GDP in 1996. Excess Capacity. As might be expected, as the volume of investments ballooned during the 1990s, often at the bequest of national governments, so the quality of many of these investments declined significantly. All too often, the investments were made on the basis of projections about future demand conditions that were unrealistic. The result was the emergence of significant excess capacity. A case in point were investments made by Korean chaebol in semi-conductor

factories. Investments in such facilities surged in 1994 and 1995 when a temporary global shortage of Dynamic Random Access Memory chips (DRAMs) led to sharp price increases for this product. However, by 1996 supply shortages had disappeared and excess capacity was beginning to make itself felt, just as the Koreans started to bring new DRAM factories on stream. The results were predictable; prices for DRAMs plunged through the floor and the earnings of Korean DRAM manufacturers fell by 90%, which meant it was extremely difficult for them to make scheduled payments on the debt they had taken on to build the extra capacity in the first place. In another example, a building boom in Thailand resulted in the emergence of excess capacity in residential and commercial property. By early 1997 it was estimated that there were 365,000 apartment units unoccupied in Bangkok. With another 100,000 units scheduled to be completed in 1997, it was clear that years of excess demand in the Thai property market had been replaced by excess supply. By one estimate, by 1997 Bangkoks building boom had produced enough excess space to meet its residential and commercial need for at least five years. The Debt Bomb. By early 1997 what was happening in the Korean semi-conductor industry

and the Bangkok property market was being played out elsewhere in the region. Massive investments in industrial assets and property had created a situation of excess capacity and plunging prices, while leaving the companies that had made the investments groaning under huge debt burdens that they were now finding difficult to service. To make matters worse, much of the borrowing to fund these investments had been in US dollars , as opposed to local currencies. At the time this had seemed like a smart move. Throughout the region local currencies were pegged to the dollar, and interest rates on dollar borrowings were generally lower than rates on borrowings in domestic currency. Thus, it often made economic sense to borrow in dollars if the option was available. However, if the governments in the region could not maintain the dollar peg and their currencies started to depreciate against the dollar, this would increase the size of the debt burden that local companies would have to service, when measured in the local currency. Currency depreciation, in other words, would raise borrowing costs and could result in companies defaulting on their debt payments. In this regard, a final complicating factor was that by

the mid 1990s although exports were still expanding across the region, so were imports. The investments in infrastructure, industrial capacity, and commercial real estate were sucking in foreign goods at unprecedented rates. To build infra-structure, factories, and office buildings, SE Asian countries were purchasing capital equipment and materials from America, Europe, and Japan. Boeing and Airbus were crowing about the number of commercial jet aircraft they were selling to Asian airlines. Semi-conductor equipment companies such as Applied Materials and Lam Materials were boasting about the huge orders they were receiving from Asia. Motorola, Nokia, and Ericsson were falling over themselves to sell wireless telecommunications equipment to Asian nations. And companies selling electric power generation equipment such as ABB and General Electric were booking record orders across the region. Reflecting growing imports, many SE Asian states saw the current account of their Balance of Payments shift strongly into the red during the mid 1990s. By 1995 Indonesia was running a current account deficit that was equivalent to 3.5% of its Gross Domestic Product (GDP), Malaysias was 5.9%, and Thailands was 8.1%. With deficits like these starting to pile

up, it was becoming increasingly difficult for the governments of these countries to maintain the peg of their currencies against the US dollar. If that peg could not be held, the local currency value of dollar dominated debt would increase, raising the specter of large scale default on debt service payments. The scene was now set for a potentially rapid economic meltdown. Meltdown in Thailand The Asian meltdown began on February 5 th, 1997 in Thailand. That was the date that Somprasong Land, a Thai property developer, announced that it had failed to make a scheduled $3.1 million interest payment on an $80 billion eurobond loan, effectively entering into defaulting. Somprasong Land was the first victim of speculative overbuilding in the Bangkok property market. The Thai stock market had already declined by 45% since its high in early 1996, primarily on concerns that several property companies might be forced into bankruptcy. Now one had been. The stock market fell another 2.7% on the news, but it was only the beginning. In the aftermath of Somprasongs default it became clear that not only were several other property developers teetering on the brink on default; so where many of the countrys financial institutions

including Finance One, the countrys largest financial institution. Finance One had pioneered a practice that had become widespread among Thai institutions --- issuing eurobonds denominated in US dollars and using the proceeds to finance lending to the countrys booming property developers. In theory, this practice made sense because Finance One was able to exploit the interest rate differential between dollar denominated debt and Thai debt (i.e. Finance One borrowed in US dollars at a low interest rate, and leant in Thai Bhat at high interest rates). The only problem with this financing strategy was that when the Thai property market began to unravel in 1996 and 1997, the property developers could no longer payback the cash that they had borrowed from Finance One. In turn, this made it difficult for Finance One to pay back its creditors. As the effects of over-building became evident in 1996, Finance Ones non-performing loans doubled, then doubled again in the first quarter of 1997. In February 1997, trading in the shares of Finance One was suspended while the government tried to arrange for the troubled company to be acquired by a small Thai bank, in a deal sponsored by the Thai central bank. It didnt work, and when trading resumed in

Finance One shares in may they fell 70% in a single day. By this time it was clear that bad loans in the Thai property market were swelling daily, and had risen to over $30 billion. Finance One was bankrupt and it was feared that others would follow. It was at this point that currency traders began a concerted attack on the Thai currency, the baht. For the previous 13 years the Thai baht had been pegged to the US dollar at an exchange rate of around $1=Bt25. This peg, however, had become increasingly difficult to defend. Currency traders looking at Thailands growing current account deficit and dollar denominated debt burden, reasoned that demand for dollars in Thailand would rise while demand for Baht would fall. (Businesses and financial institutions would be exchanging baht for dollars to service their debt payments and purchase imports). There were several attempts to force a devaluation of the baht in late 1996 and early 1997. These speculative attacks typical involved traders selling Baht short in order to profit from a future decline in the value of the baht against the dollar. In this context, short selling involves a currency trader borrowing baht from a financial institution and immediately reselling those baht

in the foreign exchange market for dollars. The theory here is that if the value of the baht subsequently falls against the dollar, then when the trader has to buy the baht back to repay the financial institution it will cost her less dollars than she received from the initial sale of baht. For example, a trader might borrow Bt100 from a bank for a period of six months. The trader then exchanges the Bt100 for $4 (at an exchange rate of $1=Bt25). If the exchange rate subsequently declines to $1=Bt50 it will only cost the trader $2 to repurchase the Bt100 in six months and pay back the bank, leaving the trader with a 100% profit! Of course, since short selling involves selling Baht for dollars, if enough traders engage in this practice, it can become a selffulfilling prophecy! In May 1997 short sellers were swarming over the Thai baht. In an attempt to defend the peg, the Thai government used its foreign exchange reserves (which were denominated in US dollars) to purchase Thai baht. It cost the Thai government $5 billion to defend the baht, which reduced its "officially reported" foreign exchange reserves to a two-year low of $33 billion. In addition, the Thai government raised key interest rates from 10% to 12.5% to make holding Baht more attractive, but since this also raised corporate borrowing

costs it only served to exacerbate the debt crisis. What the world financial community did not know at this point, was that with the blessing of his superiors, a foreign exchange trader at the Thai central bank had locked up most of Thailands foreign exchange reserves in forward contracts. The reality was that Thailand only had $1.14 billion in available foreign exchange reserves left to defend the dollar peg. Defending the peg was clearly now impossible. On July 2nd, 1997, the Thai government bowed to the inevitable and announced that they would allow the baht to float freely against the dollar. The baht immediately lost 18% of its value, and started a slide that would bring the exchange rate down to $1=Bt55 by January 1988. As the baht

. Introduction The aim of this paper is twofold. First of all, it reveals that the stock market collapses experienced by a number of South East Asian economies in 1997 and early 1998 where highly correlated with the evolution of the currencies of the countries involved. Secondly, using Price/Earnings and Price/Book ratios it is shown that Asian stock markets were not overvalued before the crisis started; thus suggesting that the crisis was not the result of a bursting bubble that some authors such as Krugman have argued. This paper also presents the different theories of stock market co-movements across countries. The presence of contagion or inter-dependence among economies of a certain region become important with the diminishment of the advantages to

investors of international diversification, via increases in cross-correlations among stock market returns. The issue of international contagion and inter-dependence has been in the forefront of academic discussions as a result of Mexico s 1994 and Asias 1997-'98 financial crises. In the second section of this paper the behavior of S.E.-Asian currencies during the crisis is analyzed. The rest of the paper is organized as follows: the third section analyzes the evolution of S.E.-Asian stock markets during the crisis; the fourth section inquires whether Asian stock markets were overvalued before the financial crisis erupted; the fifth section presents the different channels of transmission through which the stock market of one country might be influenced by the evolution of other stock markets; and, finally, the sixth section summarizes and presents the author's conclusions. 2. The Evolution of Asian Currencies During the Financial Crisis The Asian financial crisis started with the devaluation of Thailand s Bath, which took place on July 2, 1997, a 15 to 20 percent devaluation that occurred two months after this currency started to suffer from a massive speculative attack and a little more than a month after the bankruptcy of Thailands largest finance company, Finance One . This first devaluation of the Thai Baht was soon followed by that of the Philippine Peso, the Malaysian Ringgit, the Indonesian Rupiah and, to a lesser extent, the Singaporean Dollar. This series of devaluations marked the beginning of the Asian financial crisis. [2] This first sub-period of the currency crisis took place between July and October of 1997. Figures 1A and 1B (below) present the monthly evolution of the currencies of the eight South-East Asian countries studied here for the period July 1997 (rebased to 100 in all the graphs) to May 1, 1998. [3] Included are the Hong Kong (H.K. Dollar), Indonesia (Rupiah), Malaysia (Ringgit), the Philippines (Peso), Singapore (SG Dollar), South Korea (Won), Taiwan (New Dollar) and Thailand (Baht). A second sub-period of the currency crisis can be identified starting in early November, 1997 after the collapse of Hong Kongs stock market (with a 40 percent loss in October). This sent shock waves that were felt not only in Asia, but also in the stock markets of Latin America (most notably Brazil, Argentina and Mexico). In addition to these stock markets, were those of the developed countries (e.g. the U.S. experienced its largest point loss ever in October 27, 1997, which amounted to a 7 percent loss). These financial and asset price crises also set the stage for this second sub-period of large currency depreciations. This time, not only the currencies of Thailand, the Philippines, Malaysia, Indonesia and Singapore were affected, but those of South Korea and Taiwan also suffered. In fact, the sharp depreciation of Koreas Won beginning in early November added a new and more troublesome dimension to the crisis given the significance of Korea as the eighth largest economy in the world; the magnitude of the depreciation of its currency which took place in less than two months; and the Korean Central Bank s success in maintaining the peg ever since the Thais first devaluation (i.e. the nominal anchor of the largest of the Asian Tigers was suddenly lost). In addition, was the other important component of this second sub-period: the complete collapse of the

Indonesian Rupiah that started at about the same time. Finally, starting in January of 1998, the currencies of all of these countries regained part of what they had lost since the crises started. It is also important to note that at a great cost Hong Kong was able to maintain its peg after the crisis first erupted. This required that interest rates be raised to fend-off these currencies from repeated speculative attacks. 3. The Evolution of Asian Stock Markets During the Asian Financial Crisis It is necessary to study the evolution of the stock markets and the inflow of money that went to the Asian economies in order to understand the financial crisis of 1997- 1998. Net equity investments in the economies of South Korea, Indonesia, Malaysia, Thailand, and the Philippines amounted to US$ 12.2 billion in 1994, US$ 15.5 billion in 1995, US$19.1 billion in 1996, and US$ 4.5 billion in 1997 according to the Institute of International Finance in 1998. The reversal for 1997 came as a result of the financial crisis that started in Thailand, which added pressure to the currency markets of the countries considered in this article. Net equity investments and new private loans financed most of the increasing current account deficits that the SE-Asian economies, as well as most of the developing world, experienced during the 1990s. The ability of most of the developing world to import capital through securities markets was enhanced by the exponential growth in the U.S. mutual fund industry, and the low interest rates available in the U.S. and Japan during the past decade. Now, through the following figures, let us turn our attention to the behavior of the Asian stock market indices during the crisis. Figures 2A and 2B (above) show the monthly evolution of national stock price indices (expressed in US dollars) for these same eight countries and during the same period of time. The stock market indices are those provided by Morgan Stanley International Capital (MSCI). Figures 3A and 3B (below) show the behavior of the same Asian stock market indices from January 1997 to May 1998 but expressed in local currency. As can be seen, the direction of the stock markets is similar to that of Figures 2A and 2B in which the indices where expressed in US$ terms. However, the magnitude of the decline on the local stock market prices is not as pronounced when expressed in local currency. Figures 3A and 3B (above) show the behavior of the same Asian stock market indices from January 1997 to May 1998 but expressed in local currency. As can be seen, the direction of the stock markets is similar to that of Figures 2A and 2B in which the indices where expressed in US$ terms. However, the magnitude of the decline on the local stock market prices is not as pronounced when expressed in local currency. This finding suggests the existence of a currency effect affecting stock price returns during the crises, as is explained in the next paragraph. The finding of a close relationship between exchange rate depreciations and stock returns during a crisis is consistent with Bailey, Chan and Chung (2001). These authors demonstrate, using intraday data, that the severe downturn of the Mexican stock market in December 1994 and early 1995 can be associated with the Peso devaluation that took place during this same period. In the case of the five Asian

countries whose currencies experienced the sharpest depreciations during the Asian crisis (Indonesia, Malaysia, Philippines, South Korea, and Thailand) the average correlation between weekly stock market returns and currency changes (where currency is defined as the number of units of foreign currency per 1 U.S. dollar) between the first week of July 1997 and the first week of May 1998 is 0.63 and is significant at the 1percent level. My explanation for this strong association is that currency devaluations have traditionally been accompanied by declining stock markets in the developing world because they have usually taken place in the middle of a financial crisis and uncertainty about the future course of economic policies and outcomes. For instance, the negative impact of devaluing currencies on S.E.-Asian banks and companies that had borrowed heavily on international markets most probably surpassed the potential export gains. But an orderly devaluation such as that of Britain in 1992 did not have negative effects on the London stock market since it helped the British economy recover from a three-year recession via an export-boom. 4. Were the Stock Markets Overvalued Before the Crisis Started? The stock markets of Hong Kong, Indonesia, and South Korea fluctuated with no clear trend before the first sub-period of the currency crisis began in early July, 1997. The stock markets of Malaysia, Singapore, the Philippines, and Thailand drifted downward during this same sub-period, with the later two countries experiencing the sharpest declines. Finally, Taiwan's stock market drifted upwards during this same sub-period of time. Therefore, I not see any evidence of a clear pattern of stock markets collapsing in a contagious fashion before the first round of devaluations took place in July, 1997, as Krugman (1998) suggested was the case: [4] And then the bubble burst. The mechanism of crisis, I suggest, involved that same circular process in reverse: falling asset prices made the insolvency of intermediaries visible, forcing them to cease operations, leading to further asset deflation. This circularity, in turn, can explain both the remarkably severity of the crisis and the apparent vulnerability of the Asian economies to self-fulfilling crisis which in turn helps us understand the phenomenon of contagion between economies with few visible economic links. I have checked the evolution of the same national stock market indices since 1991 (the preceding five years to the crisis) and, on one hand, I found a significant increase in Hong Kongs stock market asset prices (a fourfold increase), while, on the other hand, the remaining seven stock markets stayed remarkably flat, with some minor fluctuations. Furthermore, the performance of the Asian stock markets lagged behind the Latin American, the British, and the United States stock markets during the same years prior to the crisis. Thus, it seems hard to contend that the collapse of the stock markets in South East Asia was the result of a bursting bubble, since the stock prices of the markets of SE-Asia had hardly any growth six years prior to the currency crises of 1997. To analyze whether rapidly increasing stock prices represent a bubble; financial economists try to express these prices in terms of indicators such as; the earnings

of companies which trade stocks in the market (the P/E or Price/Earnings ratio, and the P/B or Price/Book ratio.) Rising stock prices and earnings may well yield a flat P/E ratio (i.e. there is no bubble since higher stock prices are justified by fundamentals, at least as it pertains to the P/E ratio.) For instance, authors like Gilibert and Steinherr (1996) contend that the rise in stock prices that took place in Mexico in the early 1990s was the product of a speculative bubble and that it was not justified by fundamentals. However, analyzing P/E and P/B ratios of Asian stock markets just before the crisis erupted it is difficult to contend that these markets were overvalued since the ratios were below the world average (See Table 1 above.) Finally, Table 2 (above) shows that the U.S. stock market had been, on a riskadjusted basis, the best market performer during the period 1990-96, followed by Latin America, U.K., Asia (excluding Hong Kong), and Japan. The fact that S.E.Asian markets plummeted after having lagged behind the performance of those of the rest of the world, and after having remained relatively flat during the 1990s (i.e. no bubble), is another indication of how severe and dramatic the financial crisis was. Krugmans assertion is nonetheless consistent with the behavior of national stock prices in South East Asia after the first round of devaluations. Such evolution had actually preceded the second and more intense wave of devaluations of November and December of 1997. This is because, as was shown in Figures 2A and 2B (above), between the first and second round of devaluations the stock markets of Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand experienced sharp declines. Not until the currencies of these countries stabilized in early 1998 were their stock markets able to reverse the downward trend in stock prices (except in Indonesia). In summary, it is difficult to contend that falling stock prices during the Asian crises were the result of a bubble that was bursting or that Asian stock markets were overvalued before the crisis first erupted. 5. Stock Market Co-Movements: The Channels of Transmission [5] In this section the literature of the determinants of stock market co-movements is briefly examined. Why do stock market co-movements occur? What are the linkages among stock markets that can explain a crisis such as the Asian? Calvo and Reinhart (1996) provide a brief summary of the existent explanations in the context of currency crisis, [6] and in this paper an attempt is made to adapt some of these explanations to the case of stock market co-movements during periods of financial crises, a subarea in this field that has received relatively little attention. [7] Nonetheless, the inflow of capital to the developing world that took place in the late 1980s and early 1990s was accompanied by an increasing share of portfolio investments as local stock markets became increasingly open towards foreign investors. Such is the case for the Latin America countries where this situation is presented more frequently than in the South Eastern Asia countries. Stock market co-movements can be explained as follows:

The first reason is that stock market co-movements may take place when the financial markets of two countries are highly integrated so that shocks to the larger country are transmitted to the smaller ones via assets-trading. An example of this type of spillover is the integration of the capital markets of Argentina and Uruguay. As a result of Argentinas 2001-2002 severe crisis and subsequent external debt default and currency devaluation, Uruguay has recently been forced to devalue its currency. The second most important reason are the trade partners and bilateral or multilateral trade arrangements that enhance the possibilities of international shocks. For instance, when the currency of a country experiences a large real depreciation, imports from its trading partners fall, and the trade balance of the country whose currency is devalued deteriorates, thereby setting the stage for the currencies of its neighbors to suffer speculative attacks if the impact is large enough. For example, the Brazilian devaluation of 1999 placed great pressure on Argentinas currency, Brazils most important trading partner. The third reason (See Chua, 1993.) emphasizes the role of technological factors on economic growth. Technological spillovers between neighboring countries tend to occur because ideas and capital flow are faster and easier across neighboring countries rather than across distant countries. Thus, the economic growth of a country is affected by the economic growth of its neighbors. I have found a highly significant and positive regional spillover effect in a number of the South East Asian countries. The first three theories or reasons presented above attempt to explain stock market co-movements as a consequence of economic linkages among countries. These theories are what Forbes and Rigobon (2000 and 2002) might call interdependence explanations. Nevertheless, the last three theories or reasons, which are of a contagious nature, deal with the effects of investors behavior on stock markets, the result of which may cause a stock market crisis or exacerbate an existing one. The fourth reason, is that spillovers or contagious crises may occur for institutional reasons according to the theories of Calvo and Reinhart (1996) theories: [8] In response to a large adverse shock (such as the Mexican devaluation) [9] an open-end emerging market mutual fund that is expecting an increasing amount of redemptions will sell off its equity holdings in several emerging markets in an effort to raise cash. However, given the illiquidity that characterizes most emerging markets, the sell-off by a few large investors will drive stock prices lower. Hence, the initial adverse shock to a single country gets transmitted to a wider set of countries. The fifth reason is that investors sentiments can generate self-fulfilling crises if foreign investors do not discriminate among different macroeconomic fundamentals across countries. There exists a vast literature on banking and financial crises in the developed world in which the issue of contagion effects arise frequently. According to Calvo and Reinhart, for example: [10]

In the wake of a bank failure (particularly a large of prominent bank), anxious depositors possessing imperfect information about the soundness of other banks rush to withdraw their deposits from the banking system at large. The stampede by depositors generates a liquidity crisis that spreads to other healthy banks. Thus, herding behavior by depositors alters the "fundamentals" for a broader set of financial institutions and the crisis becomes selffulfilling...A similar story can be told about investors in international currency and equity markets...With regards to emerging markets, however, relatively little is known about these issues. The sixth reason is that contagion may occur because of the way market participants interpret possible co-movements in macroeconomic policies and fundamentals in the economies subject to attack. [ Eichengreen, Rose, and Wyplosz (1996) ] Given the experience of currency crisis being accompanied by stock market collapses in the developing world (The figures shown above confirmed this in the context of the SE-Asian financial crises), a speculative currency attack against one currency and the concomitant effects may well trigger simultaneous declines in the stock markets of these same countries. 6. Conclusions In this paper the currency and stock market collapses experienced by a number of South East Asian economies in 1997 and mid 1998 have been examined, and the close relationship between the behavior of their stock markets during this period and the evolution of the currencies of the countries involved was analyzed. Shown was that the severe downturn of the Asian stock markets during the financial crisis can be associated with the currency devaluations of the five countries whose currencies experienced the sharpest depreciations during the crises, especially in the case of Indonesia, Malaysia, Philippines, South Korea, and Thailand. This was reflected in an average correlation between weekly stock market returns and currency depreciations of 0.63 during the crisis period. When the evolution of South East Asian stock markets prior to the crisis was analyzed there was no evidence found of a clear pattern of stock markets collapsing in a contagious fashion before the first round of devaluations took place in July, 1997 as Krugman (1998) suggested was the case. Krugman s assertion is nonetheless consistent with the behavior of national stock prices in South East Asia after the first round of devaluations occurred. Also, the fact that South East Asian stock markets plummeted after having lagged behind the performance of those of the rest of the world, and after having remained relatively flat during the 1990s (i.e. no bubble), is another indication of how severe the financial crisis was. Stock market co-movements may occur for different reasons. First, they may take place when the financial markets of two countries are highly integrated so that shocks to the larger country are transmitted to the smaller ones via assets-trading. Second, trade partners and bilateral or multilateral trade agreements enhance the transmission of shocks internationally. Third, spillover effects may be the result of technological factors or economic growth. Fourth, contagious crisis may occur for

institutional reasons. Fifth, investors sentiment can generate self-fulfilling contagious crisis if foreign investors do not discriminate among different macroeconomic fundamentals across countries. And sixth, contagion may occur because of the way market participants interpret possible co-movements in macroeconomic policies and fundamentals in the economies subject to attack. Even though I did not test any of the theories of contagion in this article, I am inclined to think that competitive devaluations were present during the crisis and that a domino effect was created when international mutual funds sold Asian stocks and bonds of both crisis and non-crisis countries in an effort to raise cash. These two channels of transmission correspond to the second and fourth theories of contagion outlined in the previous paragraph. Finally, I conclude that contagion or interdependence across stock market returns diminishes greatly the advantages of international diversification highlighting the instability of historical correlation coefficients among stock market indices when a crisis occurs. References Bailey, W., Chan, K., and P. Chung, Depositary Receipts, Country Funds, and the Peso Crash: The Intraday Evidence, The Journal of Finance , (Dec. 2002), v55, n6, pp. 2693-2717. Calvo, S., and C. Reinhart; Capital Flows to Latin America: Is There Evidence of Contagion Effects, in Calvo, Goldstein, and Hochreiter, Private Capital Flows to Emerging Markets after the Mexican Crisis (Vienna: IIE, 1996.) Chua, H.; Regional Spillovers and Economic Growth, Center Discussion Paper No. 700. New Haven, CT: Yale University Economic Growth Center. Eichengreen, B., Rose, A., and Ch. Wyplosz;

The Asian Crisis: Causes and Cures IMF Staff The financial crisis that struck many Asian countries in late 1997 did so with an unexpected severity. What went wrong? How can the effects of the crisis be mitigated? And what steps can be taken to prevent such crises from recurring in the future? THE EAST ASIAN countries at the center of the recent crisis were for years admired as some of the most successful emerging market economies, owing to their rapid growth and the striking gains in their populations' living standards. With their generally prudent fiscal policies and high rates of private saving, they were widely seen as models for many other countries. No one

could have foreseen that these countries could suddenly become embroiled in one of the worst financial crises of the postwar period. What went wrong? Were these countries the victims of their own success? This certainly seems to have been part of the answer. Their very success led foreign investors to underestimate their underlying economic weaknesses. Partly because of the largescale financial inflows that their economic success encouraged, there were also increased demands on policies and institutions, especially those safeguarding the financial sector; and policies and institutions failed to keep pace with these demands (see table). Only as the crisis deepened were the fundamental policy shortcomings and their ramifications fully revealed. Also, past successes may have led policymakers to deny the need for action when problems first appeared. Net capital flows (billion dollars) 1994 1995 1996 1997 1998 1999 Total Net private capital flows 1 Net direct investment Net portfolio investment Other net investment Net official flows Change in reserves 2 160.5 84.3 87.8 -11.7 -2.5 -77 .2 192.0 96.0 23.5 72.5 34.9 -120 .5 240.8 114.9 49.7 76.2 -9.7 -11 5.9

173.7 138.2 42.9 -7.3 29.0 -54 .7 122.0 119.6 18.0 -15.6 37.0 -6 7.1 196.4 119.7 34.4 42.3 -8.9 -91 .1 Developing countries Net private capital flows 1 Net direct investment Net portfolio investment Other net investment Net official flows Change in reserves 2 136.6 75.4 85.0 -23.8 9.1 -42. 4 156.1 84.3 20.6 51.2 27.4 -65. 6 207.9 105.0 42.9 60.0 -3.4 -10 3.4

154.7 119.4 40.6 -5.3 17.5 -55 .2 99.5 99.1 19.4 -19.0 28.6 -37. 3 168.6 99.1 32.2 37.3 5.7 -80.8 Asia Net private capital flows 1 Net direct investment Net portfolio investment Other net investment Net official flows Change in reserves 2 63.1 43.4 11.3 8.3 6.2 -39.7 91.8 49.7 10.8 31.3 5.1 -29.0< BR> 102.2 58.5 10.2 33.5 9.3 -48.9

38.5 55.4 -2.2 -14.7 17.7 -17. 2 1.5 40.6 -7.0 -32.1 24.7 -24.4 58.8 43.7 5.3 9.8 7.0 -65.5 Source: IMF, World Economic Outlook , May 1998 (Washington). 1 Because of data limitations, other net investment may include some official flows. 2 A minus sign indicates an increase. Several factorsboth domestic and externalprobably contributed to the dramatic deterioration in sentiment by foreign and domestic investors: a buildup of overheating pressures, evident in large external deficits and inflated property and stock market values; the prolonged maintenance of pegged exchange rates, in some cases at unsustainable levels, which complicated the response of monetary policies to overheating pressures and which came to be seen as implicit guarantees of exchange value, encouraging external borrowing and leading to excessive exposure to foreign exchange risk in both the financial and corporate sectors; a lack of enforcement of prudential rules and inadequate supervision of financial systems, coupled with government-directed lending practices that led to a sharp deterioration in the quality of banks' loan portfolios; problems resulting from the limited availability of data and a lack of transparency, both of which hindered market participants from taking a realistic view of

economic fundamentals; and problems of governance and political uncertainties, which worsened the crisis of confidence, fueled the reluctance of foreign creditors to roll over short-term loans, and led to downward pressures on currencies and stock markets. External factors also played a role, and many foreign investors suffered substantial losses: international investors had underestimated the risks as they searched for higher yields at a time when investment opportunities appeared less profitable in Europe and Japan, owing to their sluggish economic growth and low interest rates; since several exchange rates in East Asia were pegged to the U.S. dollar, wide swings in the dollar/yen exchange rate contributed to the buildup in the crisis through shifts in international competitiveness that proved to be unsustainable (in particular, the appreciation of the U.S. dollar from mid-1995, especially against the yen, and the associated losses of competitiveness in countries with dollar-pegged currencies, contributed to their export slowdowns in 199697 and wider external imbalances) (see chart); international investorsmainly commercial and investment banksmay, in some cases, have contributed, along with domestic investors and residents seeking to hedge their foreign currency exposures, to the downward pressure on currencies. To contain the economic damage caused by the crisis, the affected countries introduced corrective measures. In the latter part of 1997 and early 1998, the IMF provided $36 billion to support reform programs in the three worst-hit countries Indonesia, Korea, and Thailand. The IMF gave this financial support as part of international support packages totaling almost $100 billion. In these three countries, unfortunately, the authorities' initial hesitation in introducing reforms and in taking other measures to restore confidence led to a worsening of the crisis by causing declines in currency and stock markets that were greater than a reasonable assessment of economic fundamentals might have justified. This overshooting in financial markets worsened the panic and added to difficulties in both the corporate and financial sectors. In particular, the domestic currency value of foreign debt rose sharply. While uncertainties persisted longer in Indonesia, strengthened

commitments were made elsewhere to carry out adjustment reforms. Appropriate strategies The strategies needed to restore confidence and support a resumption of growth include a range of measures, tailored to tackle the particular weaknesses of each country. These strategies are the basic ingredients of the IMF-supported programs in Indonesia, Korea, and Thailand. Monetary policy must be firm enough to resist excessive currency depreciation, with its damaging consequences not only for domestic inflation but also for the balance sheets of domestic financial institutions and nonfinancial enterprises with large foreign currency exposures. As fundamental policy weaknesses are addressed and confidence is restored, interest rates can be allowed to return to more normal levels. Financial sector weaknesses are at the root of the Asian crisis and require particularly urgent attention. In many cases, weak but viable financial institutions must be restructured and recapitalized. Those that are insolvent need to be closed or absorbed by stronger institutions. Governance must be improved in the public and corporate sectors, and transparency and accountability strengthened. Many recent difficulties spring from extensive government intervention in the economy, as well as widespread political patronage, nepotism, and lax accounting practices. In order for confidence to be restored, political leaders must send unambiguous signals that such abuses will no longer be tolerated. Fiscal policies will need to focus on reducing countries' reliance on external savings and take account of the costs of restructuring and recapitalizing banking systems. Resources will need to be reallocated from unproductive public expenditures to those needed to minimize the social costs of the crisis and strengthen social safety nets. Prospects for recovery In all of the countries at the center of the financial turmoil, its consequences have taken the form of a substantial shrinkage of investment and consumption, coupled with a rapid improvement in trade positions. For 19 98 as a whole, the aggregate current account of Indonesia, Korea, Malaysia, the Philippines, and Thailand is forecast to be $20 billion in surplus, compared with

deficits of $27 billion in 1997 and $54 billion in 1996. This forced improvement in the external situation will help to offset declines in domestic demand, but output is expected to stagnate in Indonesia and Korea, and to fall slightly in Thailand. There have already been some recoveries of exchange rates and stock markets, and as the needed policies are carried out and external positions improve, confidence should recover further during 1998. This will pave the way for a moderate rebound of growth in 1999 and solid recovery by 2000. The experiences of Argentina and Mexico following the "tequila crisis" of 199495, as well as the experiences of many other countries in similar situations, demonstrate that when policymakers are prepared to address the root causes of a financial crisis, economic recovery is likely to begin a year or so after a crisis peaks. In the East Asian case, the severity and importance of the crisis in the financial sector and other structural weaknesses in the countries concerned mean that necessary corrective measures are likely to take longer to implement than in crises that can be resolved mainly by macroeconomic adjustment. At the same time, the deep declines that have occurred in currency and financial markets suggest there is scope for relatively sharp rebounds as confidence recovers. Moral hazard Some commentators have argued that the international community's assistance to countries suffering from financial crises will only encourage more reckless behavior by borrowers, lenders, and investorsa phenomenon that is known as "moral hazard." Such moral hazard exists when the provision of insurance against a risk encourages behavior that makes the risk more likely to occur. In the case of IMF lending, concern about moral hazard stems from a perception that such assistance might weaken policy discipline and encourage investors to take on greater risks in the belief that they will only partially suffer the consequences if their investments sour. In fact, though, one of the fundamental purposes of the IMF is to limit the economic and social costs of crises. The experience of the Great Depression taught policymakers that the damage caused by systemic financial crises can be devastating and can have a global impact. This justifies a public policy role in avoiding deep and damaging crises. Nonetheless, in some instances the fact that IMF financing is available could increase the incentive for risk-taking by both potential borrowers and lenders. Policymakers could pursue more risky policies, knowing that the IMF would be there if their

policies failed. Likewise, lenders could take excessive risks if they believe that an IMF loan would enable a government or its banks to pay their debts if the country fell into financial trouble. In its policy advice, the IMF seeks to ensure that the parties to private transactions bear the costs of their actions. Policy advice on banking sector restructuring typically includes the closing of insolvent institutions and equity writedowns in institutions that are restructured. However, depositors may need to be protected up to certain limits, or safeguarded more broadly, if there is a risk of a general run on a banking system. It may therefore be difficult to avoid moral hazard altogether with respect to banks' foreign creditors, although there may be scope for arrangements in which these creditors roll over short-term loans at terms they would normally not choose to accept. Given the significant costs of financial crises for borrowers and lenders alike, it seems highly unlikely that imprudent lending and investment decisions are primarily the result of moral hazard created by the involvement of the IMF and other international financial bodies. Crises also reflect misjudgments or "irrational exuberance" that lead investors and banks to underestimate the risks in emerging markets (and then to overreact when sentiment begins to change). This underscores the need to ensure that investment decisions are supported by timely and accurate information to enable investors, lenders, and borrowers to be fully aware of a country's situation and vulnerabilities. Forestalling future crises The East Asian crisis of 199798 and the Mexican crisis of 1994 95 are the latest of a large number of crises in the past two decades. These crises have been costly for the countries directly affectedboth those where the crises began and those that might have escaped them but for spillover and contagion effects. Obviously, in view of these costs, the foremost concern for policymakers and financial markets is how to identify the causes of crises and prevent them. It is, of course, impossible to predict crises reliably. Further, for crises arising from pure contagion effects, early warning signals may not be available because these crises arise from unpredictable market reactions. It is feasible, however, to identify the kinds of weaknesses that typically make economies vulnerable to financial crises, whether or not a crisis does in fact materialize. Analysis suggests that the chances of a currency or banking crisis are increased when the economy is overheated: inflation is high,

the real exchange rate has appreciated, the current account deficit has widened, domestic credit has been growing rapidly, and asset prices have become inflated. An analysis further indicates that real appreciation of the domestic currency, an excessive expansion of domestic credit, and a rapidly rising ratio of broad money to international reserves are signals of vulnerability to pressures in currency markets. Equity price declines and deteriorations in the terms of trade can also signal vulnerability to a crisis, as can a rise in world interest rates. Indeed, a number of these variables indicated the emergence of vulnerabilities in the Asian countries most affected by the recent crisis. Indicators of vulnerability do give false signals, however, and they cannot predict crises. A key task for future policymakers is to identify and address vulnerability before crises erupt. While it may be impossible to detect and correctly interpret warning signals for all types of crises early enough, preemptive actions have meant that many potentially serious crises have been avoided in the past. In some cases, countries may need to adapt their exchange rate regime. Such mechanisms as currency pegs and currency unions have served many countries well and have helped to support their stabilization efforts. When countries adopt a pegged or fixedrate arrangement, a number of preconditions must be met. For example, the anchor currency and the rate at which the peg is set have to be appropriate and policies must be attuned to maintaining the rate. For some economies, the balance of costs and benefits seems to be shifting in favor of greater exchange rate flexibility, partly in order to avoid the risk that a fixed exchange rate might lead to excessive foreign currency exposure. The decision to exit a fixed currency arrangement is difficult, however, and ideally should be taken in a period of calm. All countries benefit from access to global capital markets and from the improvement in resource allocation associated with market-based competition for financing. Among these benefits is the competition in domestic financial sectors that the entry of foreign firms allows. At the same time, there are important preconditions for an orderly liberalization of capital movements. These include, above all else, a robust financial system supported by effective regulation and supervision of financial institutions. During the transition to an open capital account regime with a liberalized domestic financial sector, market-based instrumentssuch as reserve requirements on foreign currency deposits and short-term borrowingmay help to moderate financial flows. Prudential limits on foreign

currency exposure in the financial system are also essential. The liberalization of domestic financial systems should precedeor at least accompanythe opening up to foreign investors, since this will promote the development of domestic capital markets. Such a step would reduce the risk that capital inflows would become a substitute for the mobilization and effective intermediation of domestic financial