East Asian Crisis The Asian Financial Crisis or East Asian Crisis was a period of financial crisis that

gripped much of Asia beginning in July 1997, and raised fears of a worldwide economic meltdown due to financial contagion. The crisis started in Thailand with the financial collapse of the Thai baht caused by the decision of the Thai government to float the baht, cutting its peg to the USD, after exhaustive efforts to support it in the face of a severe financial over extension that was in part real estate driven. At the time, Thailand had acquired a burden of foreign debt that made the country effectively bankrupt even before the collapse of its currency. As the crisis spread, most of Southeast Asia and Japan saw slumping currencies, devalued stock markets and other asset prices, and a precipitous rise in private debt. Though there has been general agreement on the existence of a crisis and its consequences, what is less clear are the causes of the crisis, as well as its scope and resolution. Two factors that were identified as villain of the piece were very high current account deficit, financed by capital inflow and the problem of crony capitalism, meaning reckless bank loans to friends and relatives of the men in power. High current account deficit triggered the change in belief that these economies were not as sound as it was thought to be. Indonesia, South Korea and Thailand were the countries most affected by the crisis. Hong Kong, Malaysia, Laos and the Philippines were also hurt by the slump. China, India, Taiwan, Singapore, Brunei and Vietnam were less affected, although all suffered from a loss of demand and confidence throughout the region. Foreign debt-to-GDP ratios rose from 100% to 167% in the four large ASEAN economies in 1993±96, then shot up beyond 180% during the worst

of the crisis. In South Korea, the ratios rose from 13 to 21% and then as high as 40%, while the other northern newly industrialized countries fared much better. Only in Thailand and South Korea did debt service-to-exports ratios rise. Although most of the governments of Asia had seemingly sound fiscal policies, the International Monetary Fund (IMF) stepped in to initiate a $40 billion program to stabilize the currencies of South Korea, Thailand, and Indonesia, economies particularly hard hit by the crisis. The efforts to stem a global economic crisis did little to stabilize the domestic situation in Indonesia, however. After 30 years in power, President Suharto was forced to step down on 21 May 1998 in the wake of widespread rioting that followed sharp price increases caused by a drastic devaluation of the rupiah. The effects of the crisis lingered through 1998. In the Philippines growth dropped to virtually zero in 1998. Only Singapore and Taiwan proved relatively insulated from the shock, but both suffered serious hits in passing, the former more so due to its size and geographical location between Malaysia and Indonesia. By 1999, however, analysts saw signs that the economies of Asia were beginning to recover International investment In 1996 international investors poured perhaps $100 billion into East Asia. East Asian economies were the darlings of the world capital market: it seemed as if everyone who wanted to lay claim to any financial sophistication was diversifying into these fast-growing economies. In 1998 and 1999 these countries would be lucky if the balance of capital flows is zero: if money flowing into East Asia from the world economy's industrial core matches money flowing out of it. Now things could be worse. Among the countries hit by crisis, South Korean and Thai economies appear to be relatively stable, with low inflation rates, interest

rates at normal levels, and good prospects for renewed growth in the near future: the low level to which their exchange rates have been pushed by the crisis makes their exports extremely competitive on the world market. But things could be better: the Indonesian and Malaysian economies and polities remain unstable, to put it politely. The crisis has developed a second epicenter as reform in Russia begins a downward spiral. And investors all over the globe are fleeing from "risky" assets--driving the interest rates on assets like U.S. Treasury bonds way down, but diminishing business access to capital, bankrupting the stray highlyleveraged hedge fund, and placing economic growth in countries like Brazil at grave risk. In East Asia the sudden shift in international capital flow means that $100 billion a year that had financed investment in East Asia will no longer be there. That $100 billion had financed the employment of 20 million people working in investment industries, who dug sewer lines, built roads, erected buildings, and installed machines as both domestic and foreign investors bet that there was lots of money to be made in East Asia's industrial revolution. Now that $100 billion a year is gone. And with it the jobs of those 20 million people will go too. They will have to find new jobs. As their jobs vanish, while they search for new jobs, and even after they find new jobs they will be very annoyed: we will see just how stable and "harmonious" East Asian political systems truly are. Financial collapse But this sudden shift in investment flows has more important consequences than the forthcoming economic migration of 20 million East Asian workers out of investment industries. In order to pay for the investments they had undertaken, international investors traded dollars for local currencies: baht, ringgit,

rupiah, pesos, and won. This gave importers in East Asia $100 billion a year more to spend on imports than their economies earned in exports. This $100 billion a year has also disappeared, leaving demand for dollars by East Asians to finance imports some $100 billion a year higher than the supply of dollars to them earned from exports. Whenever demand is greater than supply prices rise: a rise in the price of dollars is a fall in the value of other currencies, which have fallen--are falling--will fall until the supply and the demand for foreign exchange are brought back into balance. In the long run (by, say, the year 2000, we hope) the fall in the value of East Asian currencies will bring the supply of and demand for foreign exchange back into balance. Falling exchange rates make East Asian goods more attractive to European and American purchasers, and so exports rise. Falling exchange rates make American and European goods expensive, and so East Asian imports fall. In the short run, however, falling exchange rates do not directly bring the supply and demand for foreign exchange into balance. A falling exchange rate means (i) that foreigners buy more East Asian goods, yes, but also (ii) that they pay fewer dollars for each good they buy. In the short run of the next year or two the two effects will roughly balance: Europeans and Americans will not have had enough time to change their spending patterns to make (i) outweigh (ii). Moreover, falling exchange rates in East Asia destroy East Asian firms and banks with dollar liabilities. Anyone who has borrowed in dollars finds the home-currency value of their debt interest and principal rising when the exchange rate falls. Firms and banks that find their rupiah-denominated earnings no longer large enough to pay their dollar-denominated debts shut down. And as

some firms and banks shut down, the willingness of people to lend to others drops. Thus in the short run of a year or two falling exchange rates will bring demand and supply of foreign exchange back into balance by creating an East Asian depression. Policies to handle the crisis Couldn't governments stop exchange rates from falling? Yes--East Asian governments could stop their exchange rates from falling by raising interest rates to and perhaps beyond sky-high levels. But high interest rates make it unprofitable to invest or build, and so cause an East Asian depression as well. In the short run East Asian governments have been damned if they let exchange rates fall, and damned if they try to keep exchange rates higher by raising interest rates. So they steer between Scylla and Charybdis, hoping to find the course of action that does the least economic damage. So can anything be done? Yes--and the IMF did it by lending to East Asia. Lending dollars to East Asian countries now will keep their exchange rates from falling as far and their interest rates from rising as high as if the countries were left on their own. With less of a decline in exchange rates, fewer firms and financial institutions with dollar liabilities will go bankrupt. With less of a rise in interest rates, fewer investment and construction projects will be cancelled. The East Asian depression will be smaller than it would be otherwise. But the IMF's resources are limited, and some must be held in reserve against potential catastrophes that have not happened yet. IMF support programs merely provide some reduction in the economic damage inflicted by the shift in patterns of international investment.


Where did this mess come from? So how did we get into this mess in the first place? Surely some mighty and glaring errors of economic policy must have been committed in order to cause this crisis in East Asia: what were they? The answer is that there weren't any mighty and glaring errors of economic policy. Oh, op-ed writers opine about "crony capitalism" and "unsustainable investment" and "weak financial systems" and "over lending." But such factors were no worse in the East Asia of 1997 that suffered such a crisis than in the East Asia of 1990 or 1985 or 1980 or 1975 that did not. And in every year before 1997 those who worried about "overlending" in East Asia were wrong: those who invested in East Asia received enormous profits, as East Asia proved to be the most rapidlygrowing and fastest-industrializing region that the world economy had ever seen. It is only the sudden shift in capital flows away from East Asia that makes investment "unsustainable" and financial systems "weak" and lending "excessive." So what caused the shift in investment patterns? Unfortunately for economists and for economics as a social science, we can't find any cause of the shift in investment patterns that is proportional to the effect. The shift in Wall Street's desires to invest in East Asia appears to have been impelled much more by the trendchasing and herding instincts of Wall Streeters--a community of people who talk to each other too much, and whose opinions often reflect not judgments about the world but simply guesses about what average opinion expects average opinion to be--than by any transformation in the fundamentals of East Asian economic development. Role of psychology

Economists talk about situations in which it is rational to be optimistic and rational investors are optimistic if they think that everyone else is optimistic, and in which it is rational to be pessimistic and rational investors are pessimistic if they think that everyone else is pessimistic. But what determines which of these "two equilibria" actually happens in the real world? What determines the switch of an economy from one such configuration to another? The transactions that economists analyze are economic transactions: purchases and sales of goods and assets made with an eye toward maximizing wealth or expected utility. But the transactions that determine which equilibrium will match investor expectations are social and psychological transactions: flows of gossip through telephone wires, the spread of rumors, people taking notice of other people's worried frowns or confident expressions--all of this taking place around the globe at the speed of light, as news and information and gossip and rumor propagate through the social network of investors. This is where we are into social psychology, that has tremendous bearing on macro outcome.


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