# 03 Chapter 3: The Asian Crisis

FLEX Course Material

Students will become informed of the economic

crisis occurred in the Asian Region in 1997.
The Students will rationalize the efforts of the
fiscal and monetary policies in stabilizing the
economy and to managing the flow of funds in
the equity market to go back to normal.

Basic Concepts

Module Goals
 # 03

At the end of this module, the students are expected to have:

Explained in Essay the Crisis that challenged a country in the Asian Region. A country to be explored about


can be any country of choice by the student. Specifically, the question given below must be the subject of the
Essay.

“ Knowing what we know about the crisis, do you think governments are better able to predict the onset of


another crisis? What kind of measures would you put in place to monitor economic and financial activity as
an early warning system?”

Learning Outcomes
 Economic Development in Asia
Chapter 3 – The Asian Crisis and Recent
Developments
Start of the Asian Crisis
• June 1997, after a sustained attack on the
currency led by currency hedge funds, the
Thai baht sustained a large devaluation.

• Currency devaluations in Malaysia, Indonesia

and the Philippines followed in July.

• The currency weakness extended to

Australia, Hong Kong and Korea currencies
in October.
 The Asian Crisis

• By early 1998, currencies fell by 35% to 55% for

Korea, Philippines, Malaysia and Thailand, and
more than 15% for Singapore and Taiwan.

• Indonesia suffered greatest fall of 80%.

• Equity prices also fell as a result of investor

uncertainty and currency volatility (Table 3.1).
 The Asian Crisis
• Thin and restricted equity markets exaggerated the
decline.

• Lack of hedging facilities forced investors to reduce

holdings dramatically.

• Interest rates were raised to help stabilize currencies and

liquidity was reduced.

• The result was a sharp decline in aggregate economic

activity in late 1997 and in 1998.
 Explanations for the Asian
Crisis
• There are three broad
explanations, none of them alone
completely satisfactory.

• First, a speculative bubble in the

housing and equity markets arose
which was funded and sustained by
excessive lending by the banking
system.
Explanations for the Asian
Crisis
• Second, external sector difficulties emerged
including slow export growth, loss of external
competitiveness and rapid growth in current account
deficits.

• Third, capital flight and investor panic spread across

the region through a contagion mechanism as a
result of globalization.
 The Asian Crisis –
The Bubble Economy (1)
• First, the bubble economy was the result of interaction
between lenders (mostly banks) that borrowed offshore
at high interest rates and relend at higher rates to
domestic investors.

• The domestic investors borrowed extensively to finance

speculative investments in the housing and equity
markets.
 The Asian Crisis –
The Bubble Economy (1)
• This created a speculative bubble that
depended on a stable exchange rate
and high profits.

• High profits became more improbable

as the boom reached its peak, which
was further undermined by the
successive devaluations in all the
economies as the crisis unfolded.

• Banking weakness was reinforced by

a lack of competition and unsound
lending practices.
The Asian Crisis –
The Bubble Economy (1)
• These included risky long term lending in local currency
using short term dollar loans from overseas lenders.

• When these borrowers defaulted it resulted in the

inability of the banks to repay these short term dollar
obligations.

• This banking crisis was also influenced by moral hazard

 The Asian Crisis –
The Bubble Economy (1)
• Moral hazard occurs when an agent takes more risk
because they are insured against the negative
consequence of such actions.

• In the case of the Asian financial crisis banks thoughts

that governments would insure a stable exchange rate.

• They also might have thought that the government would

bail them out if they found themselves in financial trouble
 The Asian Crisis –
External Sector Difficulties (2)
• Second, as the bubble of the early 1990s progressed,
current account deficits also grew as offshore
borrowing increased.

• While exports were growing rapidly, this was viewed as a

sign of strong investment and growth enhancing capital
expansion.
The Asian Crisis –
External Sector Difficulties (2)
• However, when export growth
began to sag in 1996 this large
current account deficits became
a growing liability and worry for
international investors.

• Exchange rates were tied to the

dollar and exports were hurt in
international markets as the
dollar appreciated in the mid
1990s.
 The Asian Crisis –
Contagion Effects (3)

• Third, there was a strong contagion effect as the

financial crisis spread across the region.

• Countries that had strong currencies and economies,

such as Hong Kong, Singapore and Taiwan were also
adversely affected.
 The Asian Crisis –
Contagion Effects (3)

• As the foreign exchange crisis unfolded, there was a

dramatic turn around in net private capital flows to the
region – from a $97 billion inflow in 1996 to a $12 billion
outflow in 1997.

• This $109 billion reversal was about 10% of the GDP of

the five most affected economies – Indonesia, Korea,
Malaysia, Philippines, and Thailand.
 The Asian Crisis –
Contagion Effects (3)
• There was also a dramatic
reversal in bank credit which
also amounted to about 10
percent of GDP.

• Together, the reversal of

capital flows and bank credit
created a liquidity crisis that led
to a sharp fall in income and
output.
 The Asian Crisis –
Contagion Effects (3)

• Indonesia, which had been a model of probity and

sensible policies was hardest hit by the crisis as its
exchange rate fell by over 50 percent and aggregate
incomes fell dramatically.

• This contagion effect was the result of investors pulling

out of many economies simultaneously.
 The Asian Crisis –
Contagion Effects (3)
• The pressure that arose on all the currencies of the
region could have been a combination of this contagion
effect as well as a process of “competitive
devaluations” as investment funds left the region.
 Post-Crisis Experience
• The impact of the crisis was fully felt in 1998 when all the
crisis countries and most other countries had negative or
very small rates of positive growth.

• PRC and Taiwan were the only exceptions.

• Equity prices also fell across the region in 1998.

 Post-Crisis Experience
• Beginning in 1999, there has been a recovery in growth
and equity markets.

• This recovery has been accompanied by a significant

amount of industrial and financial restructuring.

• Many countries suffered from a high level of Non-

Performing Loans (NPLs).
 Post-Crisis Experience
• To deal with these NPLs, the most affected countries
created separate agencies to deal with them. These
Asset Management Companies (AMCs) have taken
many of the bad loans and negotiated their liquidation.

• Korea and Malaysia have been particularly successful in

reducing NPLs, enabling the banking system to begin to
extend new loans.
 Post-Crisis Experience
• Thailand and Indonesia have been only moderately
successful while in the Philippines, the level of NPLs,
though small during the crisis, has crept up in recent
years.
 Social Impact of the Crisis

• The fall in output and employment created hardships

for many segments of the society in the affected
countries.

• There was significant reverse migration to rural from

urban areas as job opportunities dried up.

• Poverty levels increased between 1997 and 1998.

 Social Impact of the Crisis

• Disadvantaged groups
such as the poor,
women, children and
the elderly were the
worse hit by the crisis.

• Some adverse affects

on school enrollment
and on health
indicators were
observed.
The Recovery Part 1
 The Recovery Part 2
• Between 2002 and 2007 economic growth in the Asian
region accelerated, led by India and China. Living
standards increased and poverty fell.

• Domestic demand and foreign trade were both important

factors in the resumption of growth.

• As the recover progressed financial restructuring

proceeded and the financial systems strengthened.
 The Recovery Part 2
2005 2006 2007
Thailand 4.5 5.1 4.8
Malaysia 5.3 5.8 6.3
Indonesia 5.7 5.5 6.3
Philippines 5.0 5.4 7.2
Hong Kong 7.1 7.0 6.4
Singapore 7.3 8.2 7.7
Korea 4.2 5.1 5.0
Taiwan 4.2 4.9 5.7
China 10.4 11.7 11.9
 The Recovery Part 2
• The region has grown much richer in the decade since
the Asian crisis.

• China has emerged as a regional economic

powerhouse.

• Half the GDP of the region and one third of exports

originates in China

• China is now the largest trader in Asia overtaking Japan.

 The Recovery Part 2
• China joined WTO several years ago.

• Import GDP ratio is 34% in China versus 9% for Japan.

• Shows Japan is still somewhat protectionist.

• Middle income countries are being squeezed by China.

• In Southeast Asia in particular.

 The Recovery Part 2
• China competes in many different international markets
from labor intensive to skill intensive.

• Innovation and new products are drivers of trade in Asia

now.

• 60% of export growth in Asia is in new varieties and

products not more of the same products.

• Geography and outsourcing are important and locational

advantages are shaped by various factors.
 The Recovery Part 2

• History, availability of manpower, availability of capital,

cost of shipping and agglomeration economies all play a
role.

• Shenzen in China and Bangalore in India are examples

of agglomeration economies.

• Export processing zones help create incentives for high

growth export development and innovation.
 Recovery Part 3
• As the global economic crisis unfolds in 2009 Asia is being
adversely affected.

• Slower growth in Asia in 2009 and perhaps 2010 is anticipated.

• There will be a slowdown in export demand from Europe,

Japan and the United States.

• Asia is in good shape to offset these anticipated weaknesses

in the foreign sector with monetary and fiscal stimulus.
 Recovery Part 3
• Most countries cut interest rates in last four months of 2008.

• Falling energy and food prices should ameliorate any

tendencies toward inflation.

• There has been general fiscal stimulus.

• China’s projected $850 billion additional spending on

infrastructure in next few years.

• East Asia and Southeast Asia have current account surpluses.

 Recovery Part 3
• All countries in the region have ample foreign exchange
reserves.

• India could have a more difficult time than the rest of the
region.

• It has a large fiscal deficit which limits fiscal stimulus.

• Lack of willingness of overseas lenders to investment.

 Recovery Part 3
• As the global recession deepens greater cuts in employment and
exports in Asia.

• Could create greater social tension.

• Exacerbate poverty with reverse migration.

• Singapore, Hong Kong and Malaysia most exposed to foreign trade.

• Both Hong Kong and Singapore adversely affected in Asian crisis of

1997.
 Recovery Part 3
• Thailand’s prospects will also be adversely affected by political
uncertainty.

• Taiwan will have to fight its way through a recession that has
already begun.

• Korea has a lot of household debt which could slow the economy
further.

• But a big fiscal stimulus and currency depreciation of around 30

percent in 2008 which should boost exports.
 Recovery Part 3
• Volatility in many markets will restrain risk taking and
investment.

• Volatility causes sharp changes in balance of payments

• Puts pressure on governments to adjust their budgets to

reflect these shifts.

• It creates uncertainty in the business community

• Has a dampening impact on investment.

 Recovery Part 3
• The economic recovery continued into the second and
third quarter of 2009.

• Industrial countries and developing countries in Asia all

benefited.

• Stimulus packages were adopted by many countries

including fiscal and monetary measures.
 Recovery Part 3
Country Fiscal stimulus 2009/2010 as
a percent of GDP
China 4.8
India 0.5
Indonesia 2.5
Korea 2.7
Malaysia 5,5
Philippines 4.1
 Agenda for Reform
• In the wake of the Asian crisis,
there were a number of reforms

• Continuation of the debt

restructuring process with help of
AMCs.

• Arrangements of credit lines with

the private sector.

• Reform of exchange rate regimes

to reduce the chance of abrupt
currency devaluation.
 Agenda for Reform
• The movement of hot money that takes advantage of
large short term interest differentials was discouraged or
made illegal.

• Consideration of capital account reforms to include

possible taxes on short term capital but where not
approved.

• Possible controls on international portfolio movements

were also considered but not implemented.
 Agenda for Reform
• Minimum international standards
of financial practice were
implemented.

• Accountability and transparency

of business practices
strengthened.

• Increased international
surveillance to detect possible
future financial crises have been
considered but not implemented.
 Agenda for Reform
• Basle accords used to strengthen supervision and
regulation of banking systems.

• Introduce greater competition in financial markets while

strengthening prudential regulations.

• Improve accounting and disclosure standards.

 Agenda for Reform
• Introduce greater flexibility and depth into financial
markets including greater hedging and providing greater
access for foreign investors.

• Maintain open trading environments in keeping with

WTO and regional trading arrangements.
 Agenda for Reform
• Look into ways of restraining FDI concessions that
distort incentives and distort the flow of investment.

• Enhance the flow of technical expertise, innovation and

human capital flows and exchanges.

• Continue to undertake research into the process of

financial and economic crises.
 Growth projections
• In this section we explore prospect for future growth and
structural change.

• We begin with a simple growth model

• y = (ls) h + (1- ls) k + a

• where y is growth income h is the rate of change in education

adjusted labor input, k is the rate of growth in capital, ls is
labors share in income, (1- ls ) is capital’s share in income and
a is total factor productivity.
 Growth projections
• If we assume that the capital to output ratio is fixed in the
short run then we can substitute y for k on the right hand
side of this equation and rearrange

• y = h + a/ ls

• income growth (y) is a function of the growth of the

labor force adjusted for improved quality by higher
education and better health (h), the share of labor in total
income (ls) and TFP (a).
 Growth projections
The rest of the section looks at various assumptions
about these factors and projects growth into the future.

The main conclusion is that estimates for TFP (a) in

South Asia using the past tend to underestimate the rate
of growth.

We have also oversimplified because we haven’t looked

at saving potential.

You can read about this on pages 46 and 47.

Growth projections
• By considering the factors in these simple growth models
we can get some insights into what causes rapid growth.

• Investment

• TFP (a)

• Labor force growth (ls)

• Education and health (h)

• Governance, corruption, foreign investment also

important as indirect determinants of TFP
 Summary
• Causes of the Asian financial crisis.

• Analysis of the impact and severity of the financial crisis in affected

countries.

• Policy implications gained.

Supplementary Resources
• The Asian Crisis Four Years On by IMF
• The Asian Crisis: Cause & Cures by IMF