1997 Asian Financial Crisis Angelica M. Montefalcon 4FM2 I. Introduction For about twenty years, East-Asian countries were held up as economic idols. They were hailed as the ideal models for strong economic growth of developing countries because of their high savings and investment rates, autocratic political systems, export-oriented business, restricted domestic markets, government capital allocation, and controlled financial systems.
They were even stories about “The East Asian Miracle” because of the extraordinary growth rates they achieved and the speed with which they have transformed themselves from poor countries into industrial powerhouses. Western leaders were impressed by their ability to continue to achieve growth rates several times higher than the advanced nations, and their increasing ability to challenge or even surpass American and European technology. But, western leaders were eventually threatened by the growth of Asia.
The gap between the Western and Eastern economic performance eventually became a political issue. The new president of the United States, John F. Kennedy was alarmed that the rapid growing Eastern economies were like those of the Soviet Union and its satellite nations. Those two decades of uninterrupted progress were put to stop when the economies of East and Southeast Asia experienced a crisis. This crisis was called the 1997 Asian Financial Crisis and was the fourth international financial crisis in the world.
The 1997 Asian financial crisis explains the reasons behind the collapse of the East-Asian regional economies. II. Crisis The 1997 Asian Financial Crisis started in Thailand on July 2, 1997, when the Thai Baht collapsed because of the Thai government’s decision to float it, cutting its peg to the US dollars. After that, they called the International Monetary Fund (IMF) for technical assistance. The sharp depreciation of the baht against the US dollar began that same day.
Earlier the crisis, May 1997, the Thai Baht was already hit by massive speculative attacks from the westerners. The Bank of Thailand with the intervention of Singapore was able to defend their currency for a while by spending billions of dollars of their foreign reserves but sooner or later still failed. This immediately triggered a panic among investors and other regional currencies. This caused a chain reaction in other countries particularly those that were interlinked through trade and foreign investments.
The 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. The devaluation in the currencies in Asia caused debt to be even more difficult to repay and countries started to default. An alternative reason behind the crisis is the weaknesses in Asian financial systems. These weaknesses were caused largely by the lack of reasons for effective risk management created by implicit or explicit government guarantees against failure (Moreno, Pasadilla, and Remolona 1998).
Moral hazard is a disposition on the part of individuals or organizations to engage in riskier behavior, than they otherwise would, because of a tacit assumption that someone else will bear part or all of the costs and consequences if the incurred risk turns out badly. Moral hazard was implicit throughout the region for domestic and foreign investors. They thought that the Thai government will always be able to save them from their mistakes.
They over calculated the strength of their government and their economy and became so secluded to their own success without even thinking about the future effects of their actions. Crony capitalism is another source of the crisis experienced in Asia. Economic transactions between financial institutions and clients in Asian countries were based on so-called “special relationships”. These special relationships were “directed” and “connected” to lending and other collusive relationships. In this kind of environment where special relationships between banks and companies exist, efficient markets are impossible to develop.
Thais’ real estate business boomed, owning property and selling or leasing it for development became one of the most popular businesses in their country. Rich Thai players entered into collusion with local and foreign banks, mostly Japanese banks, to loan more money just to keep on building. Because of overbuilding, they were no longer able to rent out most of their new office and condo space. Prices dropped due to oversupply, so they couldn’t get nearly as much money on what they used to built those.
When the bank loans became due, they couldn’t pay. This also became a contributing factor in the problem faced by Thailand during the Asian currency crisis. They wern’t able to weigh whether investments in buildings are worthwhile, they were reckless and the only thing they though was the funds they were able to get for building those infrastructures. Their foreign borrowing went to prestigious projects with no solid economic returns. Another reason behind the 1997 Asian financial crisis was the large current account deficits.
Asian leaders agreed that large current account deficits could not be good, but they made the logical economic argument that if a current account deficit mostly reflects higher investment, it would eventually increase an economy’s competitiveness and therefore its ability to repay the debt, and would certainly be more sustainable than a deficit driven by consumer spending. The belief of the Asian leaders about a deficit driven by higher investments is better than deficit driven by consumer spending has an underlying assumption that most of the investment spending should be intelligently and potentially profitable.
Unfortunately, as I have stated a while ago, much of the so-called investments they have made was spent on property development that resulted in an oversupply and redundant manufacturing capacity rather than improvement in the quality and competitiveness of their exports. The rapid growth of Asia covered the weaknesses in their financial sector but the reason behind its growth will eventually prove to us that it was also one of the reasons why the crisis started. In 1994, renowned economist Paul Krugman published an article attacking the idea of an “Asian economic miracle”.
He said that East Asia’s economic growth had historically been the result of increasing capital investment and that total factor productivity had increased only marginally or not at all. Krugman argued that only growth in total factor productivity, and not capital investment, could lead to long-term prosperity. This is the reason why Asia’s economy’s success was short-term and temporary only because they have increased their capital investments but not their productivity. The fixed exchange rates to the US dollars by some of the Asian currencies also affected the 1997 Asian financial crisis.
Economic theory suggests that a pegged exchange rate system can become in danger when cross-border capital flows are highly movable. A central bank that pegs its exchange rate to a hard currency implicitly guarantees that any investors can exchange their local currency assets for that hard currency at the prevailing exchange rate indefinitely. If investors suspect that the government will not or cannot maintain the peg, they may flee the currency; this capital flight, in turn, deletes hard currency reserves and forces the devaluation they fear.
The Thai Baht was one of the Asian currencies that was pegged to the US dollars that’s why when they were no longer able to maintain their peg, Thai Baht was forced to devalue. In the previous years, they had probably kept their values low as part of their export push strategy. Almost all of the Asian economies that have been cited in the context of the Asian financial crisis have based their economic strategies on export promotion. The appreciation of the US dollars against the Asian country currencies meant a decline in the competitiveness of these East Asian countries so long as they continued to fix their currencies gainst the US dollars. Although at first, they kept their currency value low, they didn’t intend it to be super undervalued against the US dollars that happened during the crisis. The very large devaluation in the currencies in East Asia became a problem because of their foreign denominated debts. Domestic interest rates needed to maintain those pegs attracted short term capital and encouraged domestic firms to borrow in foreign currencies. Thai financial firms assumed it was absolutely safe to make foreign loans for their business clients.
The result was a flood of cheap foreign money that allowed banks to make foreign currency loans in U. S. dollars at interest rates far lower than loans in Baht. In two years, foreign borrowings in Thai financial firms almost doubled. Thai companies and individuals had already piled up a huge U. S. dollar debts. Thailand, even before the crisis was already facing severe bankruptcy. And lastly, they say that rote learning is also one of the reasons behind the Asian financial crisis. Asian schools are adequately funded but were able to produce disciplined and politically docile workers for success in low technology industries.
Asian schools failed to produce innovative and imaginative technicians and managers with developed creative thinking skills that could have helped them reach the top in the fast-paced, constantly changing knowledge-based industries. III. Case studies Before the crisis started in mid-1997, economic integration in the region was perceived as having strong synergistic effects, as it encouraged industrial growth and exports, intraregional trade, investment and technology flows. After July 1997, the crisis spread rapidly from Southeast Asia to Northeast Asia.
The “Asian 5” which were the five countries worst hit by the currency crisis are Thailand, Indonesia, Korea, Philippines, and Malaysia. Other countries like Hong Kong, Mainland China, Laos, Taiwan, Singapore and Vietnam were also affected. Japan was not affected at all but was experiencing its own recession. The Asian financial crisis also spread to Latin America. The crisis had major macroeconomic effects in the Asian counties. It includes large decrease in the values of currencies, stock markets and other asset prices of several countries.
The nominal US dollar GDP of ASEAN fell in 1998. Many banks and businesses collapse or had to be rescued and many others were forced to downsize, and as a consequence, millions of people lost their work and experienced a harder time providing themselves their basic needs. The economic crisis also led to a political upheaval, the resignations of President Suharto in Indonesia and Prime Minister General Chavalit in Thailand. There were also an increase in anti-Western sentiments with George Soros and the IMF as the targets of criticism.
George Soros, a hedge-fund operator was believed to the speculator of the Thai Baht back in 1997. The crisis affected many countries in the Asian region and had a direct impact on the livelihood of millions. It happened within a very short period of just a few months but left and most of the developed countries unharmed and the developing countries devastated. In the Philippines, just like in every country in Asia that got affected by the crisis, it started with the devaluation of their currency.
On July 3, the day after the start of the crisis, the Philippine Central Bank was forced to intervene to defend the peso, raising the overnight rate, but still, the peso fell significantly. Quickly after the financial crisis started, there has been a large downward shift in economic growth which lasted until 1998. The real GDP growth rate declined in 1997 and even had negative growth in 1998. The GNP also decreased significantly in 1997 and in 1998. Growth of investments in the Philippines also experienced a fast decline.
The lack of confidence in the overall economic environment in Asia, the difficulty of borrowing from the banking sector and low domestic demand took a toll on investment during the crisis. An analysis of growth rates by industrial origin revealed that the agriculture, fishery and forestry sector also performed poorly. The poor performance of this sector could be traced to the El Nino weather phenomenon which left quite a few areas of the country at risk of drought and several monsoon rains which affected the planting season in October 1998.
The country’s major crops, rice, corn and coconut were heavily affected by the bad weather conditions, as a result, these sectors reported productivity declines. The industrial sector was influenced by poor demand throughout most of 1998. The most distressed in the industrial sector were the construction and manufacturing sub-sectors. Overcapacity in the real estate sector was the main reason for the decline in construction business. In fact, many of the firms which declared insolvency or problems in debt repayments were real estate companies.
On the other hand, in the manufacturing sub-sector, the basic metal and non-metallic products and the transport equipment sub-sectors were severely affected by the crisis, and growth in these sub-sectors declined through much of 1998. The financial sector was also ruthlessly affected by the crisis. The major problems faced by industrial firms were high interest rates and the lack of sources of monetary funds. In response to these problems, in 1998, the Bangko Sentral ng Pilipinas tried to reduce reserve requirements, while the national government reduced Treasury bill rates.
However, in spite of these actions, total bank credit to private firms showed very little growth. Total gross domestic credit by deposit money banks even declined in March 1999. With greater economic uncertainty and the difficulty of evaluating firm creditworthiness, banks had been more discriminating in lending to private companies, and many had reduced their private sector portfolios. Selective lending by commercial banks was identified as the main reason for this phenomenon. The outflow of foreign capital was one of the problems brought by the financial crisis.
This resulted in the significant decrease in the value of the Philippine peso. The country’s balance of payments (BOP) posted a deficit in 1997, but was able to reach a surplus in 1998. But, the current account surplus dropped in 1998 due to a huge decline in net services and transfers. However, the country’s significantly lower trade deficit partially offset this decline. The deterioration of the BOP in the second half of 1997 reduced gross international reserves but improved by the end of 1998 and became even better by June 1999.
Prices increased slightly during the latter months of 1997. However, the rise in the inflation rate was mitigated by manufacturers who drew upon their existing inventories and also because of the government importing rice and corn to avoid shortages in the coming of the season of El Nino. However, as agricultural productivity worsened by the second quarter of 1998, prices started to rise over the double-digit level. Inflation peaked in October 1998, when several typhoons devastated various rice and corn areas and affected the Philippines agricultural supply.
By December 1998, inflation increased some more and continued to be at double-digit levels throughout the first half of 1999. The crisis also negatively affected the amount of government revenues they receive. At the beginning of the crisis in 1997, actual revenue they have collected fell below target because of deficits in income tax and import tax collections. Nonetheless, the government was able to achieve a surplus. By 1998, however, fiscal performance had worsened. In order to respond to the falling level of resources, the government established several policy changes.
One of the initial effects of the economic slowdown was the increase in the number of job lay-offs and the weaker demand for new labor entrants. This was driven by firm closures and downsizing in the corporate sector and the effects of the weak demand for goods and services. These job cut-backs also in some way affected the informal sector workers in rural and urban areas as demand for their products weakened. At the same time, more women and children entered the workforce to increase their family income and offset the declines in wages of the primary breadwinners.
As a result of exchange rate devaluation, the prices of imported consumer and intermediate products increased during the crisis. This had a negative effect on wages and informal sector incomes. Simultaneously, the inflation rate also lowered the purchasing power of the poor, through a rise in prices. Also, the national government’s budget experienced a period of lower revenues as a result of lower economic growth and higher expenditures on interest and maintenance and operating expenses due to higher loan rates and the higher exchange rate as a result of the crisis.
Also, some people suggested that there was a decline in income across all income groups and income inequality somewhat increased. There were also some other social effects attributed in the crisis. They said that the crisis was especially hard on women who enjoyed an improvement in their professional and wage status during the years of modest growth but who were forced to return to their former positions as unpaid family workers or unemployed housewives. Also, women had to take the burden of increased household work as the male breadwinners in the family were forced to increase their search time for additional employment.
In general, violence against women and children also increases in an economic crisis. The Asian financial crisis spilled over to Russia and then to Brazil and soon to the whole Latin American continent. They suffered a severe economic recession that drove corporations into insolvency and thus forced many to close down. It also caused the deterioration of the banking system’s financial situation and massive lay-offs that increased the existing unemployment level and caused the loss of purchasing power among large sectors of the population. IV. Mitigation
The IMF arranged rescue packages for three the countries severely affected by the crisis. They were forced to initiate a $40 billion program to stabilize the currencies of South Korea, Thailand, and Indonesia, whose economies were hit particularly hard by the crisis. The packages include measures that affect the structure of the economies concerned, such as the accountability of the corporate sector, legislated monopoly privileges and prudential regulation of the financial institutions. On 20 August, as part of an overall package of reform, the IMF approved stand-by credit for Thailand of up to $US3. billion, $US1. 6 billion was available immediately and the rest subject to performance targets and program review. The package of measures under the program included a new exchange rate regime based on floating of the baht, fiscal policy designed to produce a surplus, ending the support for insolvent financial institutions, strengthened financial regulation and supervision, accelerated privatization, and increased emphasis on secondary education and training. Indonesia has been hardest hit by the Asian financial crisis with immense falls in the exchange rate and stock prices.
The IMF believes that Indonesia’s structural weaknesses made it especially vulnerable to adverse external developments. It cites domestic trade regulations, import monopolies, lack of transparency and data deficiencies in the business environment, a weak banking system ill-prepared to survive the financial turmoil in SE Asia, and high levels of corporate overseas debt taken out after a history of stable exchange rates which proved unsustainable On November 5, the IMF announced a package including stand-by credit of $US10. 14 billion for Indonesia.
The rest of the package includes fiscal measures designed to maintain the surplus, tight monetary policy, closing unviable banks, liberalizing foreign trade and investment, dismantling domestic monopolies, private sector participation in infrastructure, expanding the privatization program, and increasing the transparency of public sector activities to enhance the quality of governance. In addition to the IMF credits the World and the Asian Development Bank also offered help. Indonesia’s own external assets are committed to the package.
In addition, Australia, as well as China, Hong Kong, Japan, Malaysia, Singapore and the US have indicated they would be prepared to consider additional monetary help to support the program in the event the IMF credit arrangements proved insufficient. Korea’s problems emerged earlier in 1997 as a number of highly leveraged chaebols became bankrupt as a result of over-investment in steel and cars, and weakened profitability with the cyclical downturn. The bankruptcies weakened the financial system and the decline in stock prices further reduced the value of bank equity. All of this led to a sharp fall in external finance.
On December 4, the IMF announced a package including a $US 21 billion stand-by credit for Korea. The package of measures agreed by Korea includes tight monetary policy with high interest rates to stabilize markets, tight fiscal policy, strengthening the financial system through a firm exit policy, market and supervisory discipline and increased competition, further trade liberalization, easing restrictions on foreign ownership, and making it easier to dismiss workers. In addition to the IMF funding, the World Bank has indicated it will provide additional money to support specific structural reform and Asian Development Bank has promised too.
As a second line of defense, Australia along with Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the UK, and US have indicated that they are prepared, in the event that there is a need for additional resources, to consider supplemental financing. The Philippines is also now a part way through an IMF adjustment program. This program pre-dates the 1997 Asian financial crisis and is of a completely different order of magnitude. The total amount available to the Philippines considerably less than the amounts involved in the other Asian countries.
The extension was in response to the effects of the regional capital market instability and the float of the baht on July 2. On the other hand, Malaysia refused IMF assistance and advice. Instead of further opening its economy, Malaysia imposed capital controls, in an effort to eliminate speculative trading in its currency. While the IMF mocked this approach when Malaysia adopted it, the IMF later admitted that the imposed capital controls succeeded. Malaysia generally suffered less severe economic problems than the other countries involved in the Asian financial crisis. V. Conclusion
The 1997 Asian financial crisis marked the end of the Asian developmental state. It is mostly a result of dysfunctional overvalued currencies caused by a huge influx of foreign investments and a sudden and fast liberalization of capital markets. It is also a result of massive corporate and private debt in foreign currencies. It is a product of crony capitalism, shortage in corrective tools, global contagion of investor panic and the problem of moral hazard. In other words, the source of their problem is their state-driven developmental model that is no longer effective in the fast growing region.
It proved to the government that their system, “the state leads, the market follows” can no longer be applied and was already broken. This has made them realize that they need to re-examine their political economic model and move towards the market-driven management. But the Asian state was too slow in restructuring its private sector economy to prevent the oncoming crisis. The most devastated countries were Indonesia, Thailand, Korea, Philippines, and Malaysia. The IMF arranged rescue packages for three the countries severely affected by the crisis and initiated a $40 billion program to stabilize their currencies.
While the Philippines already had a program from the IMF even before the crisis, Malaysia did not accept IMF’s assistance. The packages included measures that will affect the structure of the economies of the concerned countries, such as the accountability of the corporate sector, legislated monopoly privileges and prudential regulation of the financial institutions. In addition, while I was finding articles about the 1997 Asian financial crisis, I was came across this study that used the early warning system model. The people that made this project were able to prove that there were ersistent warning signals twenty-four months prior to the 1997 crisis. This proves to us that the crisis should have not been a surprise if the economists saw the signals. We can also say that the Asian leaders and the government as a whole could have done something earlier that could have prevented the happening of the crisis or even just lessen the impact of the crisis to the Southeast Asian region. VI. References B. Lucarelli. The East Asian Financial Meltdown. Journal of Contemporary Asia. (v. 32, no. 4, pp. 500-516) Eul-Soo Pang.
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