A Critical Analysis of the 1997 Asian Financial Crisis

Abstract
There exists vast literature regarding the 1997 Asian financial crisis. Wade (1998) observed that:

Interpretations of the Asian crisis have coalesced around two rival stories: the “death throes of Asian state capitalism” story about internal, real economy causes; and the “panic triggering debt deflation in a basically sound but under-regulated system” story that gives more role to external and financial system causes (Wade 1998, p.1535).
Whereas Wade supports the latter narrative based on the chronology of the crisis, this short paper holds that the combination of both stories caused the 1997 Asian financial crisis, rather than one view point being more significant than the other. The major underlying reasons, which contributed to the crisis, are categorized using the criteria described by Wade. There are some overlaps in terms of the supporting evidence and these further support the paper’s stand. This paper also presents lessons learned and not learned from the experience.
View points on Financial CrisisSupporting Evidence
‘Death throes view’– ‘Excessive government intervention in markets’ and the state-directed Asian market system (Wade 1998, p.1536)– Structural and Policy Distortions- Rapid Liberalization and Deregulation of Financial Markets*- Moral Hazard**
‘Investor pullout/Debt deflation in a sound but under-regulated system’– ‘Self-fulfilling withdrawal of short-term loans, fuelled by each investor’s recognition that all other investors are withdrawing their claims’ due to short term debts exceeding foreign exchange reserves (Wade 1998, p. 1537)– Rapid Liberalization and Deregulation of Financial Markets*- Dependence on Exports- Pegging currencies to the U.S. dollar- Excessive Borrowing and Currency Speculation- Creditor Panic- Moral Hazard**
Introduction
The 1997 Asian financial crisis signalled the end of the Asian Tigers’ “economic miracle.” Prior to the crisis, these Asian Tigers (i.e. Hong Kong, Singapore, South Korea, Taiwan) and Tiger Cubs (i.e. Thailand, Malaysia, Indonesia, the Philippines) were held as role models to developing nations on how to achieve economic growth. Criticisms and doubts about their economic policies were disregarded in favour of their strong growth rates; while financial institutions, including the International Monetary Fund (IMF) and World Bank (WB), showered them with praise (Karunatilleka 1999).
Table 1: Key Variables in 1996 – The Asian Tigers before the crisis
Investment as a Proportion of GDP (a)
Gross Savings Rate
Trade as a Proportion of GDP (b)
Share of World GDP
Real GDP Growth
Consumer Inflation
Hong Kong31.3%
30.6%
122.9%
0.6%
4.9%
6.0%
Indonesia32.1%
31.2%
20.4%
0.8%
8.0%
7.9%
Malaysia42.2%
42.6%
78.9%
0.4%
8.6%
3.5%
Philippines23.2%
15.6%
31.2%
0.3%
5.7%
8.4%
Singapore36.5%
50.1%
0.3%
6.9%
1.4%
South Korea36.8%
35.2%
28.9%
1.8%
7.1%
4.9%
Taiwan21.2%
25.1%
40.1%
1.0%
5.7%
3.1%
Thailand42.2%
35.9%
34.9%
0.7%
5.5%
5.8%
Notes:(a) GFCF plus inventories (GFCF only in the cases of Hong Kong and Singapore)
(b) Average value of exports plus imports as a proportion of GDP (including re-exports in the case of
Hong Kong, given its status as an entrepot).
Source: Karunatilleka 1999
The crisis was triggered on July 1997 due to speculative attacks on the Thai baht. Investors sold-off baht-denominated assets and withdrew dollar-denominated loans to Thai institutions. As a result, the Thai government was forced to float the baht and let go of its peg to the U.S. dollar because it did not have enough currency reserves to support its fixed exchange rate. In the succeeding months, other Southeast Asian countries followed suit as the financial crisis spread throughout the region (Hale, 2011).
By January 1998, the stock markets in many of the affected countries had lost more than 70% their pre-crisis values, their currencies had also largely depreciated against the U.S. dollar, and their governments had to seek substantial financial support from the IMF (Hill, 2003).
Table 2: Key Currency Movements from 1997 to 1999
CountryCurrency3/1/97 Rate
Lowest Rate
Maximum Depreciation
Ending Rate 1999
Change 1997-99
ChinaYuan8.30
8.30
0.0%
8.28
0.2%
Hong KongHong Kong Dollar7.74
7.77
-0.3%
7.77
-0.3%
TaiwanTaiwan Dollar27.50
34.95
-21.3%
31.50
-12.7%
IndonesiaRupiah2,398.00
16,475.00
-85.4%
7,150.00
-66.5%
JapanYen120.40
147.26
-18.2%
102.23
17.8%
KoreaWon864.40
1,967.00
-56.1%
1,142.50
-24.3%
PhilippinesPhilippine Peso26.34
46.10
-42.9%
40.40
-34.8%
SingaporeSingapore Dollar1.43
1.79
-20.5%
1.67
-14.6%
ThailandBaht25.90
55.80
-53.6%
37.60
-31.1%
Source: Vallorani 2009
What caused the 1997 Asian Financial Crisis?
Many factors are believed to have contributed to the crisis. Some of the very components credited with spurring the region’s economic development were later acknowledged as having inadvertently played a part in the subsequent financial crisis. The following are the factors that merged together to create the perfect storm which resulted in the crisis.
Structural and Policy Distortions
The aftermath of the crisis brought to light several structural and policy inefficiencies that weakened the economic foundations of several Asian economies. Governments often undertook large infrastructure projects to promote economic growth and encouraged private businesses to invest in sectors that are in line with national industrialization goals. Corsetti et al (1999, p.306) pointed out this led to a ‘structure of incentives’ within the corporate and financial sectors and ‘close links between public and private institutions.’ Furthermore, the political pressures to maintain high growth rates, the absence of an effective regulatory business framework, and a culture of crony capitalism resulted in government guarantees for private projects (Karunetilleka, 1999; Corsetti et al 1999).
Rapid Liberalization and Deregulation of Financial Markets
In the years prior to the crisis, the Asian Tigers were praised for its efforts to open up its financial markets. However, on hindsight, experts believe that the development of financial systems had not kept pace with the rapid liberalization and deregulation of financial markets. Lending standards were lenient, government’s supervision and regulation of the financial sector were weak, there was a culture of inter-connected lending, some banks were undercapitalized, and financial safety nets were not in place (Nanto, 1998; Radelet and Sachs, 1999).
Vallorani (2009) gave some insights on the effect of deregulation on the financial sector by pointing out the concept of “hot money” and the high risk-taking that was prevalent in the years prior to the crisis.
Deregulation in the financial sector led to easy money, which caused many speculative and bad loans to be made. It also led to large debt burdens. Since hot money tends to follow hot money, a feeling of “euphoria”, and “I can’t lose” mentality, pumped money into already overvalued sectors, leading to valuations that could not be sustained. It also led to a misunderstanding of the risks involved with these investments.
Dependence on Exports
Export was the main engine that propelled Asian economies to grow. However, the excessive dependence on trade had made these countries vulnerable to currency movements. During the mid 1990s, real exchange appreciations made Asian companies less competitive, especially in terms of labour cost. Additionally, over production and excess capacity led to falling export prices. Rising competition from China and Mexico were also believed to have cast some doubts about the competitiveness, growth prospects, and ability to pay loans by Asian exporters (Radelet and Sachs, 1999; Hill 2003).
Pegging currencies to the U.S. dollar
Since the currencies of most Southeast Asian economies were pegged to the U.S. dollar, the appreciation of the dollar caused the exports of these countries to become more expensive and less competitive (Hale, 2011). At the onset of the crisis, the rising dollar caused these countries to run large deficits to fund their currencies and maintain the fixed dollar rate (Karunetilleka, 1999). As governments failed to maintain the dollar peg, their currencies depreciated sharply against the dollar and contributed to the financial panic (Hill, 2003; Radelet and Sachs, 1999).
Excessive Borrowing and Currency Speculation
The high economic growth of the early 1990s led to an attitude of excessive borrowing – most of which were used to fund real estate projects. The money loaned to domestic firms for these projects were funded by borrowing excessively from abroad. The influx of money to fund these assets caused an economic bubble as real estate prices increased dramatically (Vallorani, 2009).
In the boom years, speculative loans were awarded to firms which were not credit worthy (Vallorani, 2009). As the crisis unfolded, it became apparent that many companies had a huge mismatch between liabilities that were denominated in U.S. dollars and assets that were mostly denominated in domestic currency (Hale, 2011).
Realizing that many firms would be unable to repay their loans, currency speculation began. The Thai baht was the first to fall victim to speculative attacks, as speculators sold the baht based on the belief that the exchange rate could not be maintained (Vallorani, 2009). Other Asian countries experienced the same fate. And in what seems to be a self-fulfilling prophecy, the depreciation of domestic currencies ultimately caused many firms to default on their loan payments, thereby exacerbating the crisis.
Creditor Panic
Corsetti et al (1999) attributes the crisis to panic by domestic and international investors. Radelet and Sachs (1999, p.10) also support this claim. They argued that the expectation of each investor that other investors will pull out their funds caused them to panic and behave in a herd mentality. More importantly, the ‘high level of short-term foreign liabilities relative to short-term foreign assets’ spurred each creditor to leave the country ahead of other creditors because they knew that the last short-term creditor to withdraw funds will not be repaid on time.
Moral Hazard
Radelet and Sachs (1998, p.3) pointed out that ‘over-investment in dubious activities resulting from the moral hazard of implicit guarantees, corruption, and anticipated bailouts’ is one of the main culprits as to why huge amounts of capital suddenly left Asia. In a nutshell, creditors believed that they would be bailed out in the event of a crisis. They felt confident that they would be repaid for lending to companies with close ties to the government, especially for projects with public guarantees.
Prior to the crisis, international banks had poured out huge funds to Asian domestic financial institutions without regard for sensible credit standards. This over-lending practice may have been caused by the presumption that short-term credit liabilities would be implicitly guaranteed by government intervention or IMF bailout programs (Corsetti et al, 1999).
Conclusion: Lessons learned and yet to be learned
Fifteen years after the 1997 Asian financial crisis and the experience still resonates today, especially in the context of the current global financial crisis. Valuable lessons have been learned and continue to be applied to improve economic policies and structures. However, there still remains some important learning that have yet to be realized from the past.
Lessons Learned
Pitfalls of rapid financial liberalization– Rapid financial liberalization caused weaknesses in the financial systems. Well-functioning financial systems require strong legal and regulatory infrastructures (Radelet and Sachs, 1999).
Dangers of fixed exchange rates– Fixed rates make markets very vulnerable to huge shifts and fluctuations when they can no longer be maintained (Radelet and Sachs, 1999).
Mistaken policy interventions– The initial response of the IMF and U.S. treasury exacerbated the crisis in its early stages. This supports the need for a more formal mechanism for international private debt solutions rather than IMF bailouts (Radelet and Sachs, 1999).- ‘Swift government intervention with appropriate monetary policy’ will help to lessen the impact of a financial crisis (Vallorani, 2009, p.17).
Lack of effective mechanisms to stop financial panic– ‘The solution is to develop institutions that can provide more solid foundation for well-functioning capital markets’ (Radelet and Sachs 1999, p.18).
Improvements in market/financial regulations– Regulations are needed to guarantee a ‘level playing field’ and prevent the free market economy to ‘run amok’ (Vallorani 2009, p.17)- Bank regulators should require greater transparency and must have stricter regulations in supervising lending activities (Hale, 2011).
Implement policies to prevent market speculations – Suggest to have a ‘universal tax on currency transactions’ to discourage market speculations- Another option is a fee-based system, whereby private financial institutions create an insurance fund similar to the IMF.(Karunatilleka 1999, p.39)
Updating the policies of IMF and WB– Improving global regulations- Creating a process of active and transparent surveillance for borrowing nations- Creating a code of best practices on social policy issues- Reinforcing international and domestic financial systems- Promoting more widely available and transparent data on member countries economic situation and policies- Underscoring the central role of the IMF in crisis management- Increasing the involvement of the private sector in forestalling or resolving financial crises
(Karunatilleka 1999, p. 39)
Enhancing regional surveillance and participation– Regional organisations (i.e. ASEAN) could provide warning/advise to its member countries who are heading for trouble (Karunatilleka 1999, p. 40).
The current global financial crisis has some significant similarities with the 1997 Asian financial crisis. This is proof that there are still a few lessons yet to be learned to prevent future crisis from happening. The most important lesson that keeps recurring as a major “mistake” in almost every financial crisis is aptly expressed by Vallorani (2009).
The lesson that was not learned is that speculative spending, fuelled by risky loans, leads to asset bubbles, and bubbles always burst. The Asian bubble burst in 1997. The .com bubble burst in 2000. The US real estate bubble burst in 2008. It seems to be part of human nature to chase what is hot, to chase the next “I can’t lose” investment, to not want to be left out when everyone else is making easy money. When greed takes over, bubbles are built. Unfortunately, when they burst, they take everyone with them (Vallorani 2009, p.18).
References
Agenor, P-E, Miller, M, Vines, D, Weber, A (1999). The Asian Financial Crisis: Causes, Contagion and Consequences. Cambridge United Kingdom: Cambridge University Press. p9-28.
Corsetti, G, Pesenti P, Roubini, N. (1999). What caused the Asian currency and financial crisis?. Japan and the World Economy. 11 (1), 305-373.
Hale, G. (2011). Could We Have Learned from the Asian Financial Crisis of 1997–98?. Available: http://www.frbsf.org/publications/economics/letter/2011/el2011-06.pdf. Last accessed 17th Sep 2012.
Hill, C. (2003). The Asian Financial Crisis. Available: http://www.wright.edu/~tdung/asiancrisis-hill.htm. Last accessed 17th Sep 2012.
Karunatilleka, E. (1999). The Asian Economic Crisis. Available: http://www.parliament.uk/documents/commons/lib/research/rp99/rp99-014.pdf. Last accessed 17th Sep 2012.
Moreno, R. (1998). What caused East Asia’s Financial Crisis?. Available: http://www.frbsf.org/econrsrch/wklyltr/wklyltr98/el98-24.html. Last accessed 17th Sep 2012.
Nanto, D. (1998). The 1997-98 Asian Financial Crisis. Available: http://www.fas.org/man/crs/crs-asia2.htm. Last accessed 17th Sep 2012.
Radelet, S, Sachs, J. (1999). What Have We Learned, So Far, From the Asian Financial Crisis?. Available: http://www.cid.harvard.edu/archive/hiid/papers/aea122.pdf. Last accessed 17th Sep 2012.
Radelet, S, Sachs, J. (2000). The Onset of the East Asian Financial Crisis. In: Krugman, P Currency Crises. Chicago: University of Chicago Press. p105-162.
Wade, R. (1998). The Asian Debt-and-development Crisis of 1997: Causes and Consequences. World Development. 26 (8), 1535-1553.
Vallorani, E. (2009). 1997 Financial Crisis. Available: http://www.avanti-is.com/PDF/1997%20Asian%20Financial%20Crisis.pdf. Last accessed 17th Sep 2012.

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