The Asian Financial Crisis For quite an extensive period Indonesia, Korea, Malaysia and Thailand had a stable
growth and their economic data such as inflation, fiscal position, and increase in exports showed solid perspectives to the foreign investors. Consequently, it would be accurate to state that not many economic agents anticipated the financial Asian crisis to occur. Moreover, it is relevant to understand what the causes of the Asian economic currency and financial crises of 1997-1998 were? To address this question, we will have to acknowledge two main factors that were taking place prior the crises. These were a lack of transparency, which made the investors and economical agents assume an Asian financial stability, and mislead structural and economic policies, which did not attempt to solve deficits in the balance of payments and debt tribulations. The following will rely on four main proposals of what should have been done by the policy makers in each stage of the financial crisis. The four proposals are: tax for outflow of shot-term capital, a fixed spread for the financial institutions that will apply only in the short term, a dirty exchange rate that will apply only the short term as well and an improvement of financial transparency. The Asian financial crisis took place in 1997, which had an evolution that started mainly in the 90's in countries such as South Korea, Thailand, Indonesia and Malaysia. These countries experienced a rapid international debt boost, due to shorter payments dead line. Thus, the international debt of North Korea, for instance, increased from 31.699 million dollars in 1990 to 164.345 million at the end of 1996. Thailand increased from 28.088 million dollar debt to 90.622 million in the same period. The short-debt represented 31% of the total debt in 1990 for South Korea, yet in 1996 it represented 67% (world bank report). Most parts of this debt was involved in the private sector. Without a doubt, this short-term debt represented one of the main reasons, which led to the financial crisis to occur. Furthermore it would be precise to say that Lawrence, Lincoln, Furman and Stiglitz agree that this factor was one of the main causes of the crises. This high short-term debt occurred because the Asian private entities offered a high short-term interest rate, which made the investor locate their capital in those institutions, due to the high return of investment. The second reason was that the exchange rate responded to a fixed system, meaning that the investors would not lose any funds in the conversion of one currency to another, as they withdraw their funds and take them back to their own country. This situation made the banks experience a deficit balance, which reflected high payouts to the investors and not enough assets to make the accounts balance. In addition the stabilization agencies were not aware of the financial condition of the banks, which enable them to decrease the magnitude of the crisis. Therefore, it seems clear that the financial system needed resources, which could provide them some oxygen until they could achieve to equalize their liabilities and assets. It also seems clear that the Asian banks needed a longer period to reimburse their liabilities. Yet, in order to achieve
Without creditors the banks would be in bankrupt sooner or later. the International Monetary Fund proposal to increase the interest rates violates the first rule of medicine: Do not harm the patient. which makes the transition from a lower interest rates to a higher interest rates complicated because these entities would have to agree with each other. Once this situation occurs the Asian financial entities would not even have shot-term capital. this strategy was already applied. of the fact (with new tax policy) that the capital will stay in Asia for a longer period. Another advantage of this approach is that. some investors might be prepared to withdraw the deposits that are already in the Asians accounts. another factors such as exchange rate. Once again we find ourselves in the same dilemma. It would analyze the accounting and financial situation of every Asian bank in each country and exposed that information constantly. he or she could change accounts electronically. with which a bank does a business. the first approach that comes to mind is an increased in interest rates for long-term investments and a decrease in interest rates for short-term. which would not be influence by any political tendency and interest. According to Furman and Stiglitz an increase in the interest rates represents “a signal of lack of confidence”. this way this entity would provide reports and analyses. It is not enough for a Bank to have solvency (from investment) it also needs creditors to give that solvency. Nevertheless. Let us remember that one of the major reasons for the crisis was the lack of transparency. The explanation of this fact is that once the interest rates change. if the interest rates go up the market will suspect a weakening in the financial system. we have to acknowledge the fact there are two interest rates. We can be positive about this argument. On the other hand. Moreover. the government and the market determine the interest rates. A possible solution to this matter could have been a tax creation for short-term capital outflow. In spite. This way the investors could have been attracted to invest in long-term and the market would not been affected (the interest rates stayed the same). because money does not have to pass customs. Furthermore. but it did not bring the results that were expected. Additionally. due to the higher interest rate. and exports change as well. why the creation of a regulation entity is very important. several actors such as the Central Bank. In addition. several Asians individuals were borrowing capital abroad. this regulation entity should have complete autonomy from the rest of the government. because the Banks will still have to respond to their lenders sooner or later. because the investors would not be willing to deposit funds in an institution that might not be capable to make give them back. since the government has the complete faculty to create taxes. This situation represents another problem to the Asian financial system. In the Asian case. the government could not impose taxes on borrows even if they are made in foreign countries (Asia needs to wake up the economy). That is one of the reasons. it could have been easy to apply. Because of these reasons.this task. Additionally. money supply. At the same time. However this strategy would have been difficult to control. the investor does not even have to see the money. The consequences of this mechanism (an increase in interest rates) could be even more striking than staying with the same interest rates. how could we promote the domestic investor to stay in the domestic financial system? We have seen that an increase in the interest rate would
which made the crisis even worst. Another problem that the Asian countries faced was the consequence of the fixed exchange rate. This method would encourage local individuals to search for domestic funds. which probably would not agree with each other in several aspects. the exporters are left without funds to pay their debts. For instance. In other words. because they would not have the funds that they desperately need. However. Why did the exports decreased? The main reason is that the exchange rate was fixed to the value of the dollar. A convenient mechanism could be that the government would set a mandatory low spread for the banks. many investors found the Asian market attractive. Exports are the engine of growth in many Asian countries. For instance. But. We also have to admit that this mechanism goes against the golden rules of market economy. which would lead to a vicious cycle. two or three percentage. However this mechanism would apply for a short period until the economy activates again. Thus. A logical solution to this problem could be to borrow capital from foreign institutions to maintain a fixed currency (the central banks did not have enough reserves to do so). This technique would improve the countries competitiveness by making the exports products cheaper. the banks would be obligated to reduce their profits due to the difference between lending and borrowing interest rates. because they borrowed foreign currency from offshore institutions (less interest rates) while their income in local currency was not rising at the same level. the Central Bank would have to let the exchange rate float (they run out of reserves). Needless to say. The trade theory tells us that a deficit in the current account could be solved with a depreciation of the currency. as an effect the citizens will abandon the local currency making the
. once the crisis occurred the Asian central banks no longer had reserves to keep the currency fixed. in South Korea and Thailand exports are 40% of the GDP. the citizen will abandoned the local currency due to the lack of credibility in their governments. a reduction in their exports. which is fixing the prices. and at the same time the interest rates would fluctuate according to the market. Applying a monetary policy through the interest rate. This situation will imply other problems for the banks. Additionally. this country will experience inflation. but once the dollar started to appreciate the Asian countries started to lose competitiveness.cause repercussions in other economical readings. In order to depreciate the currency. because they did not have the risk of losing investment in the conversion of one currency to the other due to the fixed exchange rate system. because they represent an important part of their economy. as a result the currency will depreciate. This is. the debtors could no longer pay their creditors. because they are no longer gaining from the fixed exchange rate. involves numerous actors and policy makers. Besides. Additionally. As it was mentioned before. if the currency stops being fixed the investors might decide to invest somewhere else. However. Asian countries were facing another immense problem. The only option that these countries could use was to let the exchange rate float. if the exports decrease the economies find themselves in serious budgets difficulties.
This way the market would stabilized itself avoiding a crisis to occur. (The Asian model. which the Asian states should have applied. which could have been controlling the financial entities constantly. Once these goals are achieved. according to other countries experience. institutions such as the IMF and prestigious economists do not seem to coincide on several politics. the companies did not care about the financial situation of the entities. they had every incentive to play a game of heads I win. we will have to measure if the benefits exceed the negative outcomes. the Asian countries should have depreciate the currency to increase the exports until the benefits would be more numerous than the disadvantages of inflation and debt payments difficulties.S savings and loan debacle is the classic example: because depositors in thrifts were guaranteed by the FSLIC. Because of this reason. the government would compensate them. The Asian countries needed institutions. such as the Latin Americans. For instance. However. this method in Asian countries would bring the negative consequences that we mentioned before. the Asian financial market showed a lack of transparency. the golden rules of the market would be established again. they had no incentive to police the lending of institutions in which they placed their money. There was no reason to bother. to sustain this dirty float. However. The financial institutions did not care about the financial conditions of their creditors either. Frankel. in which the Asian governments would have gained the trust and credibility of the Asians citizens and international investors.) Because of this reason. where the negative consequences will discourage the economy. the miracle. Yet. This proposal would have applied for a period. Sequentially the Asian countries will to maintain the exchange rate fixed until a limit. creditors of financial institutions did not receive explicit guarantees from the governments. These entities would have also publicized the financial conditions of each entity constantly. for example it has long been known that financial intermediaries whose liabilities are guaranteed by the government pose a serious problem of moral hazard. if the creditors are no longer in the capability of paying their debts. tails the taxpayers loses” (Paul Krugman) The Asian situation was more complicated. These regulations entities would not have let the financial institutions lend funds. As it was mentioned before. the crisis and the fund. which had a great reduction in their reserves. the government never had the resources to “help” these institutions when the crisis occurred and this situation made the crisis even more dramatic.currency depreciate. But. Consequently. In general. in which they were investing. the U. At this point the role of the IMF has great relevance. Of course this strategy would only apply in the short term until the Asian governments would gain its credibility back. Nevertheless. “since the owners of thrifts did need to put much of their own money at risk. without a previous study of the creditors. it seems that the governments had some connections with they main financial institutions and the main companies. Jeffrey A. because it could lend dollars to the Asian countries. It is also my belief that the Asian countries were on the same path. the only argument on which
. Finally. the inflation was so brutal that the exports could not compensate it.
That panic--and inadequate policy responses--triggered a region-wide financial crisis and the economic disruption that followed (Sachs and Radelet 1998). notably stock and land prices. which have historically performed very well. short-term economic activity has slowed or contracted severely in the most affected economies. In Thailand. but what some describe as "runs" on financial systems and currencies. If a panic unrelated to fundamentals fully explains Asia's financial crisis. Therefore. truthful entities and credibility. After the mid-1990s a series of external shocks (the devaluation of the Chinese remnimbi and the Japanese yen and the sharp decline in semiconductor prices) adversely affected export revenues and contributed to slowing economic activity and declining asset prices in a number of Asian economies. banks have no problem managing their portfolios to meet expected withdrawals. Interpreting the crisis The economic shocks affecting East Asia were not followed by a normal cyclical downturn. their policy implications vary greatly. which were partly encouraged by pegged exchange rates. even well-managed banks or financial intermediaries are vulnerable to panics. Starting in the second half of the 1980s. and in some cases by rapid increases in short-term borrowing from abroad.they agree is the fact that Asian countries needed transparency. most of East Asia enjoyed high savings and investment rates. then spreading to the rest of the region. However.
The collapse of the Thai baht in July 1997 was followed by an unprecedented financial crisis in East Asia. robust growth. Under normal conditions. reforms in the economic structure or in financial sector policy are not essential in planning Asia's recovery. thisEconomic Letter briefly reviews Asia's recent financial crisis and the two alternative views of its cause. first affecting Southeast Asia. These economies experienced a surge in capital inflows to finance productive investments that made them vulnerable to a financial panic. weaknesses in the financial sector were important contributors to the crisis. As a result. As is well known. these events were accompanied by pressures in the foreign exchange market and the collapse of the Thai baht in July 1997. dollar (measured in dollars per unit of the Asian currency). the value of the most affected East Asian currencies fell 35-83% against the U. That is. from which these economies are still struggling to recover. three months) to finance loans with longer maturities (say. To shed further light on this question. Disruptions in bank and borrower balance sheets have led to widespread bankruptcies and an interruption in credit flows in the most severely affected economies. however. and Remolona 1998 and others cited below). banks accept deposits with short maturities (say. Maturity transformation is beneficial because it can make more funds available to productive long-term investors than they would otherwise receive. Boom and bust in Asia Operating in an environment of fiscal and monetary restraint. Pasadilla. because they traditionally engage inmaturity transformation. The weaknesses of the financial sector were masked by rapid growth and accentuated by large capital inflows. a year or longer). if all depositors decided to withdraw their funds from a given bank at the same time. Some argue that these runs reflected a classic financial panic that did not reflect poor economic policies or institutional arrangements. reforms are indeed essential. While the two views are not mutually exclusive. as in the
. The result was a wave of currency depreciations and stock market declines.S. A great deal of effort has been devoted to trying to understand its causes. One view is that there was nothing inherently wrong with East Asian economies. if nations do not want to go through a crisis of this magnitude they will be obligated to involve these concepts in every day transactions. These weaknesses were caused largely by the lack of incentives for effective risk management created by implicit or explicit government guarantees against failure (Moreno. If. rapid growth was accompanied by sharp increases in asset values. An alternative view is that weaknesses in Asian financial systems were at the root of the crisis. and moderate inflation for several decades. In the year after collapse of the baht peg. The events in Thailand prompted investors to reassess and test the robustness of currency pegs and financial systems in the region. and the most serious stock declines were as great as 40-60%.
as investors tested currency pegs and financial systems in the region. First. it became apparent after the crisis that domestic lenders could not monitor adequately the financial condition of their borrowers. the very high overall debt ratios of corporate conglomerates (400% or higher) suggest that these borrowers were ultimately counting on government support in case of adverse outcomes. financial intermediaries were not always free to use business criteria in allocating credit. financial intermediaries or their owners were not expected to bear the full costs of failure. The importance of implicit government guarantees in the most affected economies is highlighted by the generous support given to financial institutions experiencing difficulties. For example. such growth allowed financial policies that shielded firms that incurred losses from the adverse effects of their decisions. However. in others. In Indonesia. Lack of incentives for risk management Two characteristics common in countries that have experienced financial crises were present in a number of East Asian economies. This was confirmed by events in 1997. In some cases. Hindsight reveals that the cumulative effect of this type of credit allocation can produce massive losses. Second. and Thailand) have experienced the most severe crises. East Asian financial institutions had incurred a significant amount of external liquid liabilities that were not entirely backed by liquid assets. in spite of slowing economic activity and declining asset values. such policies would make economies highly vulnerable during periods of uncertainty. In contrast. These responses further weakened the financial position of lenders and contributed to the uncertainty that triggered the financial crisis towards the end of 1997. First. thus increasing their vulnerability to changes in market sentiment. bad loans caused by risky lending may not lead to a run because depositors know that the government can supply enough liquidity to financial institutions to prevent any
. some otherwise solvent financial institutions may indeed have been rendered insolvent because they were unable to deal with the sudden interruption in the international flow of funds.case of a panic. rapid growth disguised the extent of risky lending. well-connected borrowers could not be refused credit. Second. a situation that worsened the severity of the crisis. why did Asia not experience crises of this magnitude before? Two explanations are likely. making them vulnerable to panics. it is apparent that this is not the entire story. and ultimately make the financial system vulnerable to collapse. South Korea. In a closed economy. As pointed out by Radelet and Sachs (1998). Closer integration with world financial markets adds dimensions of vulnerability that are not present in a closed economy. Krugman points out that such guarantees can trigger asset price inflation. as the impact of the crisis varied significantly across economies. financial intermediaries were protected by implicit or explicit government guarantees against losses. economies with more robust and well-capitalized financial institutions (such as Singapore) have not experienced similar disruptions. reduce economic welfare. For many years. notably an inability by domestic borrowers to service their debts. However. in South Korea. innovations in information and transactions technologies have linked these countries more closely to world financial markets in the 1990s. because governments could not bear the costs of large shocks to the payments system (McKinnon and Pill 1997) or because the intermediaries were owned by "Ministers' nephews" (Krugman 1998). Indeed the collapse of the Thai baht in July 1997 and of the Korean won in the last quarter of 1997 were preceded by signs of significant weaknesses in the domestic financial sector. This suggests that understanding what factors contributed to weaknesses in the financial sectors of the most affected economies may help make them less vulnerable to financial crises in the future. As a result of this maturity transformation. In particular. those economies with the most vulnerable financial sectors (Indonesia. In particular. when the government encouraged banks to extend emergency loans to some troubled conglomerates which were having difficulties servicing their debts and supplied special loans to weak banks. poorly managed firms could obtain loans to meet some government policy objective. Why a crisis now? Since weaknesses in East Asian financial systems had existed for decades and were not unique to the region. the bank would not have enough liquid assets to meet its obligations. reducing the incentive to manage risk effectively. threatening the viability of an otherwise solvent financial institution.
during periods of uncertainty. The lack of hedging also added to the instability in Asian financial markets once the crisis hit. and Taiwan) were in a better position to provide such assurances than those economies where such reserves were relatively low (South Korea. thus worsening the crisis. Conclusion A review of East Asia's experience suggests that while a classic panic may have played a role. went bankrupt. After the pegs collapsed. Indonesia. This implies that it would be prudent to accompany efforts to spur recovery in East Asia by reforms designed to strengthen the financial system. that same injection of liquidity can destabilize the exchange rate. In an open economy. (Singapore and Hong Kong are excluded from this comparison because their role as offshore financial centers clouds interpretation of the data. While the absence of hedging significantly lowered the cost of funds (in the short run) for those firms with access to foreign credit. Such weaknesses appear to reflect the inability of lenders to use business criteria in allocating credit and implicit or explicit government guarantees against risk. Malaysia. Those East Asian economies where foreign exchange reserves were large relative to their short-term borrowing (Philippines. The high cost of abandoning currency pegs induced policymakers to adopt harsh contractionary measures (involving skyrocketing interest rates) to defend the exchange rate. the consequent mispricing of foreign credit contributed to excessive capital inflows and the vulnerability of borrowers with heavy exposure to foreign currency loans. As a result.losses to depositors. in some cases. runs or speculative attacks on a currency can be avoided only if the holders of domestic assets are assured that the government can meet the demand for foreign currency. and Thailand).) Financial sector vulnerability was accentuated by a tendency not to hedge foreign currency borrowing in countries with pegged exchange rates. backed by foreign reserves that would be made available through central bank currency intervention. financial sector weaknesses were a major contributor to the recent financial crisis.
. The efforts of market participants to cover previously unhedged foreign currency exposure after the onset of the crisis further weakened Asian currencies. borrowers who had not hedged their foreign currency borrowing had difficulty servicing their debts and. Market participants may have interpreted currency pegs as implicit government guarantees against the risk of currency volatility (Dooley 1997). even when the pegs were unsustainable in the face of adverse market sentiment.