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CRS Report

THE 1997-98 ASIAN FINANCIAL CRISIS

Dick K. Nanto, Specialist in Industry and Trade Economics Division

February 6, 1998

SummaryThe Asian financial crisis involves four basic problems or issues: (1) a shortage of foreign

exchange that has

caused the value of currencies and equities in Thailand, Indonesia, South Korea and other Asian

countries to

fall dramatically, (2) inadequately developed financial sectors and mechanisms for allocating

capital in the

troubled Asian economies, (3) effects of the crisis on both the United States and the world, and (4)

the role,

operations, and replenishment of funds of the International Monetary Fund.

The Asian financial crisis was initiated by two rounds of currency depreciation that have been

occurring

since early summer 1997. The first round was a precipitous drop in the value of the Thai baht,

Malaysian

ringgit, Philippine peso, and Indonesian rupiah. As these currencies stabilized, the second round

began with

downward pressures hitting the Taiwan dollar, South Korean won, Brazilian real, Singaporean

dollar, and

Hong Kong dollar. Governments have countered the weakness in their currencies by selling

foreign exchangereserves and raising interest rates, which, in turn, have slowed economic growth and have made

interest-

bearing securities more attractive than equities. The currency crises also has revealed severe

problems in the

banking and financial sectors of the troubled Asian economies.

The International Monetary Fund has arranged support packages for Thailand, Indonesia, and

South Korea.

The packages include an initial infusion of funds with conditions that must be met for additional

loans to be

made available.

This financial crisis is of interest to the U.S. government for several reasons. First, attempts to

resolve the

problems are led by the IMF with cooperation from the World Bank and Asian Development Bank

and

pledges of standby credit from the Exchange Stabilization Fund of the United States. Second,

financial

markets are interlinked. What happens in Asian financial markets also affects U.S. markets. Third,

Americans are major investors in the region, both in the form of subsidiaries of U.S. companies

andinvestments in financial instruments. Fourth, the currency turmoil affects U.S. imports and exports



as well

as capital flows and the value of the U.S. dollar; the U.S. deficit on trade is now rising as these

countries

import less and export more. Fifth, the crisis is causing economic turmoil that is exposing

weaknesses inmany financial institutions in Asia; some have gone bankrupt. The economic problems of the

troubled Asian

economies are adversely affecting the United States, Japan, and others.

The U. S. Congress is likely to consider the Asian financial crisis within three broad legislative

contexts. The

first is in the financing and scope of the activities of the IMF. This includes legislation to provide

the IMF

with an increase in its quotas or capital subscriptions, New Arrangements to Borrow, an allocation

of Special

Drawing Rights, and an amendment to the IMF's Articles of Agreement. The second legislative

context is in

the impact of the crisis on the U.S. economy and American financial institutions. Forecasters

foresee a

decline in U. S. growth and an increase in the U.S. trade deficit because of the crisis. The third

context is in

efforts to liberalize trade and investment in the world.

Chronology of the Asian Financial Crisis

Early May (1997) - Japan hints that it might raise interest rates to defend the yen. The threat never

materializes, but it shifts the perceptions of global investors who begin to sell Southeast Asiancurrencies

and sets off a tumble both in currencies and local stock markets.

July 2 - After using $33 billion in foreign exchange, Thailand announces a managed float of the

baht. The

Philippines intervenes to defend its peso.

July 18 - IMF approves an extension of credit to the Philippines of $1.1 billion.

July 24 - Asian currencies fall dramatically. Malaysian Prime Minister Mahathir attacks "rogue

speculators" and later points to financier George Soros.

Aug. 13-14 - The Indonesian rupiah comes under severe pressure. Indonesia abolishes its system

of

managing its exchange rate through the use of a band.

Aug. 20 - IMF announces $17.2 billion support package for Thailand with $3.9 billion from the

IMF.

Aug. 28 - Asian stock markets plunge. Manila is down 9.3%, Jakarta 4.5%.

Sep. 4 - The peso, Malaysian ringgit, and rupiah continue to fall.

Sep. 20 - Mahathir tells delegates to the IMF/World Bank annual conference in Hong Kong that

currency

trading is immoral and should be stopped.

Sep. 21 - George Soros says, "Dr Mahathir is a menace to his own country."Oct. 8 - Rupiah hits a low; Indonesia says it will seek IMF assistance.





(4) the role, operations, and replenishment of funds of the International Monetary Fund.

The crisis was initiated by two rounds of currency depreciation that began in early summer 1997.

The first

round was a precipitous drop in the value of the Thai baht, Malaysian ringgit, Philippine peso, and

Indonesian rupiah (see Figure 1). As these currencies stabilized at lower values, the second roundbegan with

downward pressures hitting the Taiwan dollar, South Korean won, Brazilian real, Singaporean

dollar, and

Hong Kong dollar. (See Figure 2.)In countering the downward pressures on currencies,

governments have

sold dollars from their holdings of foreign exchange reserves, bought their own currencies, and

have raised

interest rates to foil speculators and to attract foreign capital. The higher interest rates, in turn,

have slowed

economic growth and have made interest-bearing securities more attractive than equities. Stock

prices have

fallen. In November 1997, this decline in stock values was transmitted to other stock markets in

the world,

although U. S. and European markets have subsequently recovered.

This financial crisis is of interest to the U.S. government for several reasons. First, financial

markets are

interlinked. What happens in Asian financial markets also may affect U.S. markets. Second,

American banks

and companies are significant lenders and/or investors in the region, in terms of bank loans,subsidiaries of

U. S. companies, and investments in financial instruments. Third, attempts to resolve the problems

have

been led by the International Monetary Fund (IMF) with cooperation from the World Bank and

Asian

Development Bank. Some legislative issues dealing with IMF funding and operations were

deferred by the

105* Congress at the close of its recent session. In 1998, Congress is considering New

Arrangements to

Borrow by the IMF, a proposed increase in IMF quotas or capital subscriptions, and a proposed

amendment

to the IMF's Articles of Agreement. Congress also may intensify its oversight U.S. activities in the

IMF.

The fourth reason that the Asian financial crisis is of interest to the United States is that the

turmoil affects

U.S. imports and exports as well as capital flows and the value of the U.S. dollar. The U.S. deficit

on trade is

now rising as these countries import less and export more. Fifth, the crisis is exposing weaknesses

in manyfinancial institutions in Asia. Some have gone bankrupt. The economic problems of the so-called



Asian Tigers

not only are adversely affecting the economies of Japan and others in the region, but, to some

extent, an

economic slowdown could spread to Latin America and the United States. Sixth, the crisis may

impede theprogress of trade and investment liberalization under the World Trade Organization and the Asia

Pacific

Economic Cooperation (APEC) forum.

So far, the International Monetary Fund has arranged support packages for Thailand, Indonesia,

and South

Korea, and extended and augmented a credit to the Philippines to support its exchange rate and

other

economic policies. The three support packages are summarized in Table 1. The total amounts of

the packages

are approximate because the IMF lends funds denominated in special drawing rights (SDRs), and

because

pledged amounts may change as circumstances change. The support package for Thailand was

$17.2 billion,

for Indonesia about $40 billion, and for South Korea $57 billion. The United States pledged $3

billion for

Indonesia and $5 billion for South Korea from its Exchange Stabilization Fund (ESF) as a standby

credit that

may be tapped in an emergency. The U. S. Treasury lends money from the ESF at appropriate

interest ratesand with what it considers to be proper safeguards to limit the risk to American taxpayers.

The support packages are initiated by a request from the country experiencing financial difficulty.

This

request then requires an assessment by IMF officials of the conditions in the requesting nation. If a

support

package is approved, the IMF usually begins with an initial loan of hard currency to the borrowing

nation.

Subsequent amounts are made available (usually quarterly) only if certain performance targets are

met and

program reviews are completed. If the financial situation continues to deteriorate, commitments

for funds

that have been pledged by the World Bank, Asian Development Bank and certain nations may be

tapped. The

funds borrowed by the recipient country usually go into the central bank' s foreign exchange

reserves. These

reserves are used to supply foreign exchange to buyers, both domestic and international.

Table 1. IMF Financial Support Packages

(Amounts in U.S.$Billion)

Thailand Indonesia South KoreaDate Approved



(1997)August 20 November 5 December 4

Total Pledged $17.2 $40 $57

IMF $3.9 $10.1 $21.0

U. S. None $ 3.0 $5.0

World Bank $1.5 $ 4.5 $10.0Asian Development $1.2 $ 3.5 $ 4.0

Bank Japan $4.0 $ 5.0 $10.0

Others $6.6 $26.0 $ 7.0

Change in Exchange Rate -38% -81% -50%

(7/1197- 1/22/98)

Change in Stock Market -26% -40% -30%

(7/1/97-1/19/98)

Source: International Monetary Fund, Dialogue Database, Wall Street Journal, Financial Times.

In addition to support packages by the IMF, other international organizations have been addressing

the

Asian financial crisis. On November 3-5, 1997, the Group of Fifteen developing nations met in

Malaysia and

developed a plan to avert renewed currency turbulence. In preparation for the Asia Pacific

Economic

Cooperation (APEC) summit meeting, senior finance officials of APEC met in Manila on

November 18-19 and

developed a framework for dealing with financial crises in the region. This Manila Framework

was endorsed

by the eighteen leaders of the economies of APEC at the forum's annual summit in Vancouver,BC, on

November 25, 1997. The Manila Framework recognized that the role of the IMF would remain

central and

included enhanced regional surveillance, intensified economic and technical cooperation to

improve

domestic financial systems regulatory capacities, adoption of new IMF mechanisms on

appropriate terms in

support of strong adjustment programs, and a cooperative financing arrangement to supplement,

when

necessary IMF resources. 1

On December 1, 1997, the finance ministers of the Association of Southeast Asian Nations

(ASEAN-Indonesia,

the Philippines, Singapore, Thailand, Malaysia, Myanmar, Brunei, Laos, and Vietnam) agreed to

make

additional funding available for any future bailouts for troubled economies in the region. It would

be

provided only if a country accepted an IMF support package and if ASEAN members consider

IMF funds to

be inadequate.2 On December 15, 1997, ASEAN heads of state endorsed the Manila Framework,efforts of the





information

to the public, including investors, on its program design and provisions imposed as a condition for

borrowing allow for accurate assessment and accountability. The sixth is prevention-whether the

IMF has

sufficient leverage over non-borrowing member countries to prevent financial crises fromoccurring.5

With respect to the scale of financial crises, it is clear that recent liberalization of capital markets

and

advances in telecommunications have increased the scale of financial crises. The size of the

support

packages for South Korea and Indonesia have been unprecedented. The question is whether the

IMF has

sufficient resources to handle more financial crises, particularly if they occur simultaneously.

With respect to moral hazard, the opinion of the IMF is that governments in trouble usually are too

slow

in approaching the Fund for help because of the conditions the IMF places on such support.

According to

the IMF, the real moral hazard is not with governments engaging in unsound lending but that,

because

IMF support is available, the private sector may be too willing to lend. Private sector financial

institutions

know that a country in trouble will go to the Fund rather than default on international loans. 6

Others,

moreover, assert that the IMF is perpetuating the moral hazard that lies at the heart of the problemfor

troubled economies like South Korea-the absence of bankruptcy. Some corporations in certain

countries

have not been allowed to fail because of political or other reasons. In the words of one

commentator,

"Capitalism without bankruptcy is like Christianity without hell. There is no systematic means of

controlling sinful excesses."7

With respect to contagion, the track record of the IMF in stopping the spread of the financial crisis

within

Asia has not been reassuring. Outside of Asia, however, the crisis has yet to spread, although

currencies

in Brazil and other countries also have depreciated somewhat.

With respect to IMF conditionality, this continues to be hotly debated with each IMF support

package.

Some claim the monetary and fiscal policies required by the IMF are too stringent and slow

economic

growth too much. The World Bank, in particular, reportedly fears that the slowdown in economic

growth

in the troubled Asian economies will only worsen their economic problems.8With respect to transparency, critics of the IMF claim that the institution does not release sufficient





Thailand. ll

The IMF also placed certain conditions on Thailand. These reportedly included that the country

commit

itself to maintaining foreign exchange reserves at $23 billion in 1997 and $25 billion in 1998,

slash itscurrent account deficit to about 5% of GDP in 1997 and to 3% of GDP in 1998, and show a budget

surplus

equal to 1% of its GDP in FY1998. The IMF Support Package for Indonesia

For Indonesia, the IMF announced a support package on November 5, 1997, that totaled $40

billion. The

package included first-line financing amounting to about $23 billion to include: 12

IMF standby credit of SDR 7.338 billion (about $10.14 billion) with SDR 2.2 billion (about $3.04

billion)

available immediately and further disbursements after March 15, 1998, provided that certain

targets have

been met;

technical assistance and loans from the World Bank of $4.5 billion,

technical assistance and loans from the Asian Development Bank of $3.5 billion, and

$5.0 billion from Indonesia's contingency reserves. In addition, a number of other countries or

monetary

authorities have committed to provide a second line of supplemental financing "in the event that

unanticipated adverse external circumstances create the need for additional resources to

supplement

Indonesia's reserves and the resources made available by the IMF." These include:Japan-$5.0 billion,

Singapore-$5.0 billion,

United States-$3.0 billion

$1.0 billion each from Australia, Malaysia, China, and Hong Kong. . Previously, Singapore also

had

promised an additional $5 billion to Indonesia in foreign exchange, if needed, to purchase rupiah.

13

Funds from the United States are in the form of a back-up line of credit from the Exchange

Stabilization

Fund 14 at appropriate interest rates. The U.S. Treasury characterized this as contingent financial

support

to be used as a temporary "second line of defense" in the event that unanticipated external

pressures were

to give rise to a need to supplement Indonesia' s own reserves and the resources made available by

the

IMF. Since the fund is under the control of the Secretary of the Treasury, use of its funds does not

require

congressional approval. Treasury, however, has indicated that if funds are disbursed, they would

carryproper safeguards to limit the risk to American taxpayers.15



As part of the support package, Indonesia was required to restructure certain banks, dismantle a

quasi-

governmental monopoly on all commodities (except rice), cut fuel subsidies, increase electricity

rates,

increase the transparency of public policy and budget-making processes, and speed upprivatization and

reform of state enterprises. It was not required, however, to change its national car policy or

aircraft

development program. The IMF Support Package for South Korea

The IMF support package for South Korea was announced in Seoul on December 3, 1997 and was

formally

approved by the IMF on the following day. It eventually consisted of $57 billion as follows: 16 *

IMF -

three-year standby credit of SDR 15.5 billion (about $21 billion),

World Bank-$10 billion,

Asian Development Bank-$4 billion.

United States-$5 billion from its Exchange Stabilization Fund,l7

Japan-$10 billion,

$ 1 billion each from the United Kingdom, Germany, France, Australia, Canada, and Italy,

additional support from Belgium, the Netherlands, ana Switzerland. The funds are contingent

upon South

Korea' s remaining in compliance with the IMF arrangement.

In return for accepting the IMF emergency loans, Korea agreed to several conditions and reforms

in orderto strengthen its economy. On the macroeconomic side, the conditions included:

reducing its current-account deficit to no more than 1% of GDP for 1998 and 1999 (about $5

billion),

capping its yearly inflation rate at 5% in 1998 and 1999,

building international reserves to more than two months of imports by the end of 1998, and

recognizing that economic growth (in terms of GDP) for 1998 would likely fall from 6% to around

3%. In

terms of financial restructuring, the IMF required a comprehensive restructuring and strengthening

of

Korea' s financial system in order to make it more sound, transparent, and efficient. The strategy

comprised three broad elements: a clear and firm exit policy, strong market and supervisory

discipline,

and increased competition. The measures included:

requiring that all banks that fail to meet the Basle Committee capital standards be restructured and

recapitalized to include mergers and acquisitions by foreign institutions and losses by

shareholders,

replacing the government guarantee of bank deposits by the end of the year 2000 with a regular

deposit

insurance system,upgrading accounting and disclosure standards to include audits of financial statements of large



financial

institutions and semi-annual disclosure of nonperforming loans, capital adequacy, and ownership

structures and affiliations,

requesting passage of legislation to make the Bank of Korea independent with price stability as its

overriding mandate and setting up an agency to consolidate financial sector supervision, andallowing foreign banking and securities companies to establish affiliated companies in Korea by

the

middle of 1998. In terms of structural policies, the IMF package required the Korean government

to take

several measures. These included:

setting a timetable in line with World Trade Organization commitments to eliminate trade-related

subsidies, restrictive import licensing, and Korea's import diversification program (aimed at

Japan),

increasing to 50% (from 26%) the ceiling for foreign investment in listed Korean firms and further

increasing it to 55% by the end of 1998,

by the end of February 1998, taking steps to liberalize other capital account transactions, including

restrictions on access by foreigners' to domestic money market instruments and corporate bond

markets,

and

easing labor dismissal restrictions under mergers and acquisitions and corporate restructuring. 18

Frank-

Sanders Amendment

The support packages of the IMF appear to be subject to the requirements of the Frank-Sanders

amendment (U.S.C. 22 § 262p-4p). Among its provisions, the Frank- Sanders amendment requiresthe U.

S. Treasury to direct the U. S. Executive Directors of the International Financial Institutions (such

as the

IMF and World Bank) to use the voice and vote of the United States to urge the respective

institution to

adopt policies to encourage borrowing countries to guarantee internationally recognized worker

rights

and to include such rights as an integral part of the institution's policy dialogue with each

borrowing

country. In testimony before the House Banking Committee in November 1997, the U.S. Treasury

indicated that it had "spoken out within the World Bank and IMF, in advancing the purposes of the

Frank-

Sanders Amendment, to promote measures that would help improve the conditions of workers in

Indonesia, Thailand, and across the developing world.''l9 Others believe, however, that the IMF's

Indonesian support package was not in accord with the Frank-Sanders Amendment.20 Bailout?

IMF assistance to the above three countries has been criticized for "bailing out" commercial banks

and

private investors at the expense of other less-favored groups and U. S. taxpayers. The IMF insists,

however, that its assistance has been provided to support programs that are designed to deal witheconomy wide, structural imbalances and not to protect commercial banks and private investors



from

financial losses.21 A more stable exchange rate may contribute to a recovery on stock markets or

better

business conditions, but there is no IMF "bailout" of specific investors.

As for bailouts of manufacturing or other nonfinancial corporations, the IMF claims that there areno

provisions in the IMF-supported programs for public-sector guarantees, subsidies, or support for

them.

Shareholders and creditors bear losses, although individual governments may devise separate

policies for

dealing with such cases. Any company in need of foreign exchange, however, usually is better off

when

foreign exchange markets are stabilized.

As for financial corporations, the IMF recognizes that governments often guarantee accounts of

certain

categories of depositors (deposit insurance). Liquidity support also can be provided to

undercapitalized,

but solvent, financial institutions. According to the IMF, however, such support normally requires

that

institutions be capable of actually being recapitalized and restructured to restore them to health.22

Imprudent lenders or investors in the recipient countries have not escaped real losses. In Korea,

for

example, the operations of 14 of 30 merchant banks have been suspended. The remaining

merchant banksalso are to be closed unless they submit rehabilitation plans. Two commercial banks in Korea also

will be

required to be recapitalized and restructured. In Indonesia, 16 insolvent banks have been closed,

and

weak but viable banks have been required to submit rehabilitation plans. In Thailand, 56 of 91

finance

companies are to be liquidated. As for investors in equity markets, they also have incurred losses.

In

January 1998, U. S. Federal Reserve Chairman Alan Greenspan indicated that because of the

financial

crisis, foreign investors in Asian equities (excluding those in Japan) had lost an estimated $700

billion-

including $30 billion by Americans.23

Another aspect of moral hazard is whether the IMF support packages rescue creditors in New York

Tokyo,

and Europe from their poor lending decisions. There is little doubt that banks which have loans

outstanding in Asia have much to gain by a return to stability in Asian financial markets. To the

extent

that the IMF support packages have contributed to that stability and to the extent that the infusionof





capital is to

reduce their trade deficits, and, in some cases, to generate a trade surplus. This is already

occurring in

South Korea. Much of this increased trade surplus for Asia is likely to come at the expense of the

UnitedStates.

The second macroeconomic mechanism by which the Asian financial crisis affects the U.S.

economy is

through capital flows. As the contagion began and Asian banks and corporations began to face

severe

financial difficulties, a concern arose in the United States that Asian holders of American financial

assets,

particularly U.S. Treasury securities, might be forced to pull them out of the U. S. economy in

order to

generate much needed cash. It seems, however, that a "flight to quality" occurred instead. Both

American

and foreign investors withdrew liquid capital (by selling securities and not rolling over loans) from

the

troubled Asian countries and moved them into the United States. This has eased the upward

pressure on

U. S. interest rates and is likely to have a positive effect on U. S. economic growth. Economic

Growth

Forecasters project that U.S. economic growth will slow by 1.3 percentage points (or 34%) from

3.8% in1997 to about 2.5% in 1998.2' (See Figure 3.) This U.S. slowdown is being caused primarily by

two

factors: the Asian financial crisis and tightness in U.S. labor markets. Most forecasters estimate

that the

Asian financial crisis will reduce U.S. growth in 1998 by 0.5 to 1.0 percentage point.

A comparison of forecasts for U.S. economic growth made in January 1998 with those made

before the

onset of the Asian financial crisis in July 1997, however, reveals one unexpected result. The

forecasts for

economic growth made in January 1998, in most cases, were higher than those published in July

1997

before the crisis. The main reason for this seems to be that in mid-1997 forecasters were wary of

the

Federal Reserve Board's concern over the run-up in the U.S. stock market, tightening labor

markets, and

the likelihood that the Federal Reserve would raise U.S. interest rates. These concerns were eased

by the

correction in the U.S. stock market in October 1997 and by the financial turmoil in Asia. The

rising U.S.trade deficit with Asia, therefore, is expected to be offset by the easing of upward pressures on



U.S.

interest rates. Trade Deficit

Forecasters expect the 1998 U.S. trade deficit to increase significantly because of the drop in the

value of

currencies in Asia, net capital inflows, and the slowdown in growth in those economies. (SeeFigure 4) The

capital inflows into the United States and outflows from the troubled Asian economies imply that

the

respective current accounts 28 must move in the opposite direction. For the United States, a rise in

the

surplus in the capital account implies an offsetting rise in the deficit in the U.S. current account -

most of

which is trade in goods and services.

As shown in Figure 4, the consensus of 50 forecasters compiled by Blue Chip Economic

Indicators is for

real net exports of goods and services to decline by about $43 billion from an estimated -$146.3

billion in

1997 to -$189.2 billion in 1998. Prior to the Asian financial crisis, the consensus forecast compiled

by

Blue Chip Economic Indicators was for the balance of real U. S. exports and imports of goods and

services

to improve and for the deficit to become smaller in 1998. From July 1997 to January 1998, the

consensus

forecast for this balance worsened by $63 billion.Standard & Poor's Data Resources, Inc. expects the U.S. merchandise trade deficit (customs value)

to

increase by $33.5 billion from $182.7 billion in 1997 to $216.2 in 1998 and further to $248.1

billion in

1999. It expects the U.S. deficit on current account likewise to rise by $27.3 billion from $163.8

billion in

1997 to $191.1 billion in 1998 and further to $211.8 billion in 1999. 29

As shown in Figure 5, the United States already runs a deficit in its merchandise trade with the

Asian

countries that have experienced currency problems - except for South Korea. In most cases, the

deficits are

estimated to remain high or increase in 1997. Microeconomic Effects

On a microeconomic level, the Asian Financial Crisis affects those industries most closely linked

to the

economies in question. The following provides a rough outline of the major U.S. sectors affected.

U.S. creditors and investors in Asia-U.S. banks, pension funds, and investors stand to lose on their

pre-

crisis exposures, but "bottom fishers" may gain as Asian equity markets recover and currencies

strengthen.U.S. exporters to Asia-U. S. makers of major export items, such as heavy equipment, aircraft,



manufacturing machinery, and agricultural commodities are seeing demand for their products

decline. U.

S. producers of commodities used in the manufacture of products in Asia also are experiencing

soft prices

(e.g. chemicals, cotton, copper, and rubber).U.S. businesses that compete with imports from Asia - U. S. manufacturers of automobiles,

apparel,

consumer electronics, steel, and other products that compete with imports from Asia are likely to

see

increased competition and downward pressures on prices. Exporters from Korea, however, report

that

they are experiencing difficulty obtaining foreign exchange to finance imports needed in their

production

processes. This, in turn, constrains their exports. U. S. labor engaged in manufacturing competing

products tend to be hurt by Asian exchange depreciation.

U.S. businesses related to interest rates-mortgage bankers, refinancing companies, builders, and

other

businesses that benefit from lower rates of interest are seeing greater activity.

U.S. businesses the sell imports from Asia-distributors and retailers of products from the troubled

Asian

economies are likely to have increased activity. These include discount retailers and Korean

automobile

dealers.

U.S. multinational corporations seeking market access in Asia-U.S. companies, particularly in thefinancial sector, that have encountered barriers to entry or restrictions on their activities in

Indonesia,

Thailand, and South Korea are likely to benefit from the market opening required by the IMF

support

packages. They also may be able to buy existing firms that need restructuring and recapitalization

at

relatively low prices.

U.S. multinational corporations with manufacturing subsidiaries in Asia -Most U.S. companies

with direct

investments in the region will probably weather the storm, although some investments (such as the

new

General Motors plant in Thailand) have been thrown into question. Since about 60% of the output

from

U.S. manufacturing subsidiaries in Asia is sold in the region, local sales are likely to stagnate until

economic growth resumes. Some excess capacity may emerge. For a manufacturing subsidiary in

a

country with a depreciated local currency, its cost of imported components will tend to rise, but

the price

of the finished export to the U.S. and other hard currency markets will tend to fall.U.S. industries that use components from Asia-U.S. manufacturers that use parts and other inputs



from

Asian countries whose currencies have depreciated are likely to experience lower costs of

production. An

overall indicator of the effect of the Asian financial crisis on U.S. businesses is the outlook for

corporateprofits. The increased competition from imports combined with rising wage costs in the United

States is

expected to reduce the growth in U.S. corporate profits in 1998 to about 4.7% or roughly half the

increase

in 1997.30

Causes of the Financial Crisis

The causes of financial problems in these countries are many and differ somewhat from economy

to

economy. In general, the Asian Tiger economies had been growing at rates of 5 to 10% per year

for the

past decade. They were opening their economies to foreign direct investments, foreign goods and

services,

capital flows, and were relying heavily on dollar markets, particularly the United States, to absorb

their

exports. In order to attract foreign investments and facilitate capital flows, their currency exchange

rates

were kept in fairly close alignment with the U.S. dollar or a basket of currencies dominated by the

dollar.

The financial services sector in most of these newly industrialized economies had been developingrapidly

and without sufficient regulation, oversight, and government controls. As capital markets were

liberalized, banks in these countries could borrow abroad at relatively low rates of interest and re-

lend

the funds domestically. Over the past decade, foreign borrowing by these countries had shifted

from a

preponderance of government to private sector borrowing. Whereas in the 1970s, the governments

might

have borrowed for infrastructure development from the World Bank or a consortium of

international

banks, in the 1990s, a local bank might borrow directly from a large New York money center

bank. The

financial crisis in Asia began in currency markets, but this exchange rate instability was caused

primarily

by problems in the banking sectors of the countries in question.

The causes and structural factors contributing to the financial crises include:

private-sector debt problems and poor loan quality,

rising external liabilities for borrowing countries,

the close alignment between the local currency and the U. S. dollar,weakening economic performance and balance-of-payments difficulties,







and

repayment are tallied, the country can face difficulties. It is a type of fallacy of composition. Even

if each

individual loan is financially viable, the total of all loans may not be so because the nation may be

short ofthe foreign exchange necessary to meet the repayment schedules.

Although Japan is not considered to be one of the Asian economies experiencing a currency crisis,

it has

been experiencing many of the same problems that are confronting its Asian neighbors. Japan's

banking

sector, for example, carries an estimated $600 billion in questionable and nonperforming loans

despite

aggressive writeoffs in recent years.34 When world attention began to be focused on Japan's

problem of

nonperforming bank loans, its government first announced in 1994 that the total amount of such

loans was

about $136 billion. A year later, it admitted that the total was more like $400 billion or about 9%

of gross

national product. Private analysts, however, put the figure at roughly double that amount.35 Since

1992, the

top 20 Japanese banks have written off approximately 35 trillion yen (about $290 billion) in bad

loans.36

Still, the combination of the weak Japanese stock market, weak real estate values, and sluggish

economycontinues to threaten Japan' s banks as well as securities companies.

Although the currency crisis has not affected mainland China's renminbi to a large extent, China

still has the

potential of experiencing a major financial crisis. The problem began in 1981 when the

government changed

the banking system from one in which banks financed investments and provided funds to

enterprises as part

of the government's central plan to one based more on banking principles. Banks were to provide

funds only

as loans rather than as investments and were to charge interest and require repayments. Suddenly,

the flow

of funds from the banks to state-owned enterprises became liabilities that had to be repaid.

China's four state-owned specialty banks do 75% of the nation's deposit and loan business. Data

on the

condition of these banks is sketchy, but in late 1994, the four banks reported over 570 billion yuan

(about

$68 billion) in bad loans or about 20% of all the loans they had issued. Overdue loans were 11.3%,

idle loans

7.7% and uncollectible loans 1.3%. These accounted for 90% of the officially recognized badloans in the





economies

and Germany 33.6%. Table 2. International Claims (Loans) by Banks in Selected Developed

Nations on

Borrowers in Troubled Asian Economies December 31, 1996 ($Millions)

Claims on by- U.S. U K. Germany Japan WorldIndonesia 5,279 3,834 5,508 22,035 55,523

South Korea 9,355 5,643 9,977 24,324 99,953

Malaysia 2,337 1,417 3,857 8,210 22,231

Philippines 3,902 1,173 1,820 1,558 13,289

Taiwan 3,182 2,773 2,628 2,683 22,363

Thailand 5,049 3,128 6,914 37,525 70,181

Total Above Asia 29,104 17,968 30,704 96,335 283,540

Asian Offshore Banking Centers

Hong Kong 8,665 26,216 26,811 87,462 207,164

Singapore 5,727 22,523 40,767 58,809 189,310

Total Asian Offshore 4,392 48,739 67,578 146,271 396,474

Total Asia + Asian 57,888 66,707 98,282 242,606 680,014

Offshore Centers

Total World 130,053 68,325 173,101 169,699 993,134

Total Offshore 35,617 63,024 119,170 219,690 663,897

Banking Centers

Total World + 165,670 131,349 292,271 389,389 1,657,031

Offshore Centers

Asia as % of World 34.9 50.8 33.6 62.3 41.0(Including Offshore Banking Centers)

Note: Data are for lending which is outside of the home market (does not include domestic

lending). Data from offshore banking centers are not completely compatible with BIS reporting

country data. Source: Bank for International Settlements. The Maturity, Sectoral and Nationality

Distribution of International Bank Lending. Second Half 1996. Basle, Switzerland, July 1997. P.

19-20.

Japan's bank exposure was particularly high. It reported 62.3% of its international lending to these

Asian

countries. In the offshore centers, Japan reported $87.5 billion in Hong Kong and $58.8 billion in

Singapore.

For Thailand, Japan reported $37.5 billion in claims, and more than $20 billion each in Indonesia

and South

Korea.

The U. S. Federal Financial Institutions Examination Council provides more recent data that those

available

through the Bank for International Settlements (BIS) used above. BIS data also have been adjusted

somewhat

to eliminate double counting and to be consistent across reporting nations. The Council data

indicate thatU.S. bank claims in these Asian economies declined after December 1996 from $45.2 billion for











for

growth in these countries. The securities firm, J.P. Morgan, for example, lowered its forecast for

economic

growth for ASEAN (Indonesia, Malaysia, Singapore, Thailand, Philippines, Brunei, and Vietnam)

for 1998from 5.9% in June 1997 (before the crisis began) to 2.2% in November 1997.45 Forecasters

expect economic

growth in South Korea to drop from 5.9% in 1997 to around -1.5% in 1998.46 Current Account

Imbalances

The high growth rates among the Asian countries had begun to create problems for them in

balancing their

current and trade accounts. The current account is a nation's balance of trade in imports and

exports plus

net income from foreign investments, and unilateral transfers. It consists of the payments for

goods and

services, interest and dividends, and remittances by foreign workers to their home countries.

Figure 10

shows current account balances for four of the Asian nations that have had to depreciate their

currencies.

(Comparable data for Malaysia were not available from the IMF.) In the case of Thailand, its

deficit in its

current account had been widening from 1992. In 1996, the deficit had grown to $14.7 billion for

the year.

As a percent of gross domestic product, this deficit had reached 8%. The IMF considers that whencurrent

account deficits reach 5 to 8% of GDP, they merit close monitoring. 47 This deficit was the

primary reason

for the downward pressure on the baht. By the time Thai authorities tightened economic policies,

investors-

both foreign and domestic-were pulling funds out of the country, and the currency crisis had

already

developed.

South Korea's current account deficit also worsened considerably in 1996. For the year, it was

$23.1 billion.

The current account deficit for the Philippines, on the other hand, had shrunk somewhat. Capital

Flows

The primary reason that the deteriorating current account balance for these nations had not placed

severe

downward pressures on their exchange rates earlier was that foreign capital was flowing in from

other

countries. Foreign investors, businesses establishing manufacturing subsidiaries, international

banks lending

to local borrowers, and others were providing a steady stream of foreign exchange and a positivebalance on





According to Alan Greenspan, Chairman of the U.S. Federal Reserve, "In retrospect, it is clear that

more

investment monies flowed into these economies than could be profitably employed at modest

risk."50 One

impetus behind these flows was the run up in the U.S. stock market and the desire of investors todiversify

their holdings. Much of the direct investment went toward building production capacity -some of

which may

be unused as these economies slow. Weak Governmental Institutions

The rapidity with which the Asian economies have grown and liberalized their financial markets

has meant

that the development of the financial systems in some economies has not kept pace with

development of the

financial markets. To varying degrees, there have been lax lending standards, weak supervisory

regimes,

inadequate capitalization, excessive inter-connected lending, and a more general lack of a credit

culture.51

Safety nets such as deposit insurance has been lacking in some countries. Problems have

developed, and

governments often have hid the true extent of those troubles.

One concern has been lack of skilled manpower. Analysts point out that as private banks and other

financial

institutions have developed in these Asian tiger economies, they frequently have gone to

governmentbureaucracies and hired away officials with the skills and experience necessary to run their

companies.

Foreign banks, in particular, have been faced with the dual problem of not having the skilled

personnel

necessary for their operations and needing someone on staff who is familiar with the bureaucracy

and has

the connections necessary to work with government officials. An important source of such

personnel has

been the government finance ministries and other agencies. This exodus of skilled officials in

some of the

countries exacerbated the problem of regulating the rapidly developing financial sectors.

Speculation

The role of currency speculation in the 1997 Asian currency crisis has been sharply debated.

Malaysian

Prime Minister Mahathir has blamed large foreign investment funds, particularly hedge fund

manager

George Soros, for attacks in the marketplace on the Malaysian ringgit and other currencies in

order to

generate profits for themselves without regard to the livelihood of the Malaysian or other localpeople. At a









related to the IMF. These include a proposed allocation of SDRs6' and a proposed amendment to

the IMF's

Articles of Agreement. The former would help to ease reserve constraints experienced by many

IMF

members. The latter, whose language has not yet been agreed, would provide the IMF with amandate to

foster capital account liberalization. The rising U.S. trade deficit combined with heightened

competition

from imports from countries with depreciated currencies may intensify political pressures to

protect U. S.

industries from foreign competition. Initiatives to liberalize imports or provide fast-track

negotiating

authority to the President may face higher hurdles. U. S .lending institutions that are highly

exposed to the

Asian financial problems also could develop problems of their own.

The Asian financial crisis also could put a damper on negotiations to liberalize trade and

investment in

Asian markets. Some of the countries affected have been reluctant to proceed with more trade and

investment liberalization until they are able to regroup and recover from their current problems.

FOOTNOTES:

1 Asia Pacific Economic Cooperation. APEC 97 Leaders Declaration. November 25, 1997. 2

Associate Press.

Asian Officials Establish Supplementary Bailout Fund. AP Newswire. December 2, 1997. 3

ASEAN. JointStatement of the Heads of State/Government of the Member States of ASEAN on the Financial

Situation.

December 15, 1997. Available on the Internet at . 4 Boorman, Jack. The Changing Emphasis of the

Fund,

Implications for Stabilization and Growth Policies. Paper presented at the IMF Seminar, Asia and

the IMF.

September 19, 1997. Hong Kong.

5 These questions are discussed in more detail in CRS Report 98-56, The International Monetary

Fund 's

(IMF) Proposed Quota Increase: Issues for Congress, by Patricia A. Wertman.

6 Boorman, Jack. The Changing Emphasis of the Fund, Implications for Stabilization and Growth

Policies.

Paper presented at the IMF Seminar, Asia and the IMF. September 19, 1997. Hong Kong.

7 South China Morning Post, January 8, 1998. P. 3.

8 Davis, Bob and David Wessel. World Bank IMF at Odds over Asian Austerity. Wall Street

Journal, January

8, 1998. P. A5, A6.

9 See, for example, Sachs, Jeffrey. Power Unto Itself. Financial Times, December 11, 1997. P. 11.

10 The "Special Drawing Right" or SDR is an international reserve asset created by the IMF andused to



denominate its accounts. In mid-1997 one SDR was worth $1.36.

1l International Monetary Fund. IMF Approves Stand-by Credit for Thailand. Press Release No.

97/37, August

20, 1997.

12 International Monetary Fund. IMF Approves Stand-by Credit for Indonesia. Press Release No.97/50,

November 5, 1997.

13 Sen, Siow Li. Singapore-Indonesia Deal to Support Rupiah Confirmed. Singapore Business

Times (Internet

edition), November 27, 1997.

14 As of December 1997, the United States had assets equivalent to about $30 billion, excluding

SDRs and

accounts receivable, in its Exchange Stabilization Fund (ESF). This was about 22% less than ESF

assets of

$38.2 billion as of December 31, 1994, at the onset of the Mexican Peso crisis. Mexico drew a

total of $12.0

billion in short- and medium-term swaps from the ESF. Mexico also drew $1.5 billion in short-

term swaps

under lines of credit with the U.S. Federal Reserve. If activated, the standby credit line for

Indonesia of $3.0

billion would equal about 10.1% of ESF assets at the end of March 1997. For background on the

Exchange

Stabilization Fund, see: CRS Report 95-262, The Exchange Stabilization Fund, by Arlene Wilson.

15 Summers, Lawrence, Testimony on the Asian Financial Crisis, November 13, 1997. 16International

Monetary Fund. IMF Approves SDR 15.5 Billion Stand-By Credit for Korea. Press Release No.

97/55,

December 4, 1997. Reuters. Korean IMF Bailout. Reuters Newswire. December 3, 1997. Yoo,

Cheong-mo.

Korea, IMF Agree on Terms, Including Foreign M&A of Korean Firms, Ownership Limit Rise.

Korea Herald,

December 4, 1997. On Internet at . Note: A special drawing right (SDR) had a value of about 1.4

dollars.

17 Korea Bailout Conditioned On Structural Reforms. DowJones Newswire. December 3, 1997.

18 IMF, IMF Approves SDR 15.5 Billion Stand-By Credit for South Korea. 19 Summers,

Lawrence, Testimony

on the Asian Financial Crisis, November 13, 1997. 20 Statements by Representatives Barney

Frank and

Bernard Sanders at the House Banking Committee hearing on the Asian Financial Crisis,

November 13, 1997

and January 30, 1998, and January 30, 1998.

21 International Monetary Fund. IMF Bail Outs: Truth and Fiction. January 1998. Available on the

Internetat: .



23 U.S. Federal Reserve Board. Testimony of Chairman Alan Greenspan before the Committee on

Banking

and Financial Services, U.S. House of Representatives, January 30, 1998. Available on the Internet

at .

24 Citicorp. Fourth Quarter Report. January 20, 1998. P. 1. 25 Bank of America. BanlcAmericaFourth

Quarter 1997 Earnings. January 21, 1998. P. 15. 24 Citicorp. Fourth Quarter Report. January 20,

1998. P. 1.

25 BankofAmerica. BanlcAmerica Fourth Quarter 1997 Earnings. January 21, 1998. P. 15.

26 J.P. Morgan. Fourth Quarter and 1997 Full Year Results. January 1998. P. 4. Available on

Internet at .

27 Blue Chip Economic Indicators. January 10, 1998.

28 Trade in goods and services plus income from foreign investments and unilateral transfers.

29 Standard & Poor's DRl. Review of the U.S. Economy, January 1998. P. i.

30 Blue Chip Economic Indicators, January 10, 1998.

31 For further information on South Korea, see: CRS Report 98-13 E, South Korea's Economy

and 1997

Financial Crisis, by Dick K. Nanto.

32 Uchitelle, Louis. Economists Blame Short-term Loans for Asian Crisis. New York Times on the

Web.

January 8, 1998. At

33 Fischer, Stanley. How to Avoid International Financial Crises and the Role of the International

Monetary

Fund. Speech given in Washington, DC, October 14, 1997.34 See: CRS Report 96-837, Japan 's Banking "Crisis ": Bad Loans, Bankruptcy, and Illegal

Activity, by Dick K.

Nanto. Unrecoverable Loans Held by Banks Reaches Y79 Trillion. Nihon Keizai Shimbun,

December 6, 1997

(morning edition). P. 1.

35 CRS Report 95-1034 E, Japan 's Banking Crisis: Causes and Probable Effects, by Dick K.

Nanto.

36 Bad Loan Write-offs by Major Banks Total 35 Trillion Yen. Kyodo Newswire article.

September 21, 1997.

37 He, Dexu. Key Financial Reform Goals. Jinrong Shibao. November 2, 1993. 38 Sun,

Shuangrui.

Subordinate Specialized Bank Commercialization to Enterprise Reform (In Chinese). Beijing

Caimao Jingji,

March 11, 1996. P. 7-13. 39 Xiong, Tang. Pool Collective Wisdom and Efforts to Explore New

Ideas on Bank

and Enterprise Reform-A Roundup of the Conference on the Strategy for Coordination of the

Reforms of

State-owned Enterprise and Bank Systems (in Chinese). Beijing Jinrong Shibao, January 5, 1997.

p.3.40 U.S. Federal Financial Institutions Examination Council. Country Exposure Lending Survey.





International Monetary Fund 's "New Arrangements to Borrow " (NAB), CRS Issue Brief 97038,

by Patricia A.

Wertman. Updated regularly.

59 Additional information on the GAB may be found in, U.S. Library of Congress. Congressional

ResearchService. The IMF's General Arrangements to Borrow (GAB): A Background Paper, CRS Report

97-467, by

Patricia A. Wertman.

60 More details on U.S. budgetary treatment of the IMF may be found in, U. S . Library of

Congress.

Congressional Research Service. U.S. Budgetary Treatment of the International Monetary Fund.

CRS Report

96-279 E, by Patricia A. Wertman.

61 On September 21, 1997, the Interim Committee of the Board of Governors of the IMF

announced

agreement on a one-time, targeted special allocation of SDR 21.4 billion(currently about $29.0

billion). This

proposal would require congressional authorization, but no appropriation.

For more information on the allocation of SDRs, see U.S. Library of Congress. Congressional

Research

Service. The IMF's Proposed Special Drawing Rights' (SDRs) Allocation: A Background Paper,

CRS Report

97-738 E, by Patricia A. Wertrnan.

APPENDIXTable A1. Exchange Rates for Selected Asian Economies, 1997-98

Date Indonesian Malaysian Philippine Thai Hong Kong Japanese South Korean Singaporean

Taiwan

Rupiah Ringgit Peso Baht Dollar Yen Won Dollar Dollar

Jan 3 2,362.9 2.52 26.25 25.7 7.74 116.32 841.3 1.40 27.48

Jan 31 2,371.2 2.49 26.33 25.9 7.75 121.20 863.1 1.41 27.42

Feb 28 2,391.4 2.48 26

The Asian



Financial

Crisis

Charles W.L.Hill

University of Washington

Asian ContagionBetween June 1997 and January

1998 a financial crisis swept

like a brush fire through the

"tiger economies" of SE Asian.

Over the previous decade the SE

Asian states of Thailand,

Malaysia, Singapore, Indonesia,

Hong Kong, and South Korea,

had registered some of the most

impressive economic growth

rates in the world. Their

economies had expanded by 6%

to 9% per annum compounded,

as measured by Gross Domestic

Product. This Asian miracle,

however, appeared to come to

an abrupt end in late 1997

when in one country after

another, local stock markets andcurrency markets imploded.

When the dust started to settle

in January 1998 the stock

markets in many of these states

had lost over 70% of their value,

their currencies had

depreciated against the US

dollar by a similar amount, and

the once proud leaders of these

nations had been forced to go

cap in hand to the International

Monetary Fund (IMF) to beg for

a massive financial assistance.

This section explains why this

happen, and explores the

possible consequences, both for

the world economy, and for

international businesses?

BackgroundThe seeds of the 1997-98 Asian





in commercial and residential

property, industrial assets, and

infra-structure . The value of

commercial and residential real

estate in cities such as HongKong and Bangkok started to

soar. In turn, this fed a building

boom the likes of which had

never been seen before in Asia.

Office and apartment building

were going up all over the

region. Heavy borrowing from

banks financed much of this

construction, but so long as the

value of property continued to

rise, the banks were more than

happy to lend. As for industrial

assets , the continued success of

Asian exporters encouraged

them to make ever bolder

investments in industrial

capacity. This was exemplified

most clearly by South Korea’s

giant diversified conglomerates,or chaebol , many of which had

ambitions to build up a major

position in the global

automobile and semi-conductor

industries.

An added factor behind the

investment boom in most SE

Asian economies was the

government. In many cases the

government had embarked

upon huge infra-structure

projects. In Malaysia, for

example, a new government

administrative center was been

constructed in Putrajaya for M

$20 billion (US$8 billion at the

pre July 1997 exchange rate),

the government was funding

the development of a massivehigh technology



communications corridor, and

the huge Bakun dam, which at a

cost of M$13.6 billion was to be

the most expensive power

generation scheme in thecountry.

Throughout the region

governments also encouraged

private businesses to invest in

certain sectors of the economy

in accordance with "national

goals" and "industrialization

strategy". In South Korea, long a

country where the government

played a pro-active role in

private sector investments,

President Kim Young-Sam urged

the chaebol to invest in new

factories. Mr. Kim, a populist

politician, took office in 1993

during a mild recession, and

promised to boost economic

growth by encouraging

investment in export orientedindustries. Korea did enjoyed

an investment led economic

boom in the 1994-95 period, but

at a cost. The chaebol , always

reliant on heavy borrowings, built

up massive debts that were

equivalent, on average, to four

times their equity.

In Malaysia, the government

had encouraged strategic

investments in the semi-

conductor and automobile

industries, "in accordance with

the Korean model". One result

of this was the national

automobile manufacturer,

Perusahaan Otomobil Nasional

Bhd, which was established in

1984. Protected by a 200%import tariff and with few other



competitors, the Proton, as the

car was dubbed, sold well in its

captive market. By 1989

Perusahaan Otomobil Nasional

Bhd was selling 72,000 cars outof a total market of 117,000. By

1995 it had a 62% share of a

market which had grown to

225,000 cars annually. Whether

this company could succeed in a

competitive marketplace,

however, was another question.

Skeptical analysis note that in

1987 an average 1,600cc Proton

cost about three times per

capita income in Malaysia; by

1996 a 1,6000cc Proton costs

5.5 times per capita income –

hardly what one would expect

from an efficient enterprise.

In Indonesia, President

Suharato has long supported

investments in a network of an

estimated 300 businesses thatare owned by his family and

friends in a system known as

"crony capitalism". Many of

these businesses have been

granted lucrative monopolies by

the President. For example, in

1990 one the President’s

youngest son, Mr Hutomo, was

granted a monopoly on the sale

of cloves, which are mixed with

tobacco in the cigarettes

preferred by 9 out of 10

smokers in Indonesia. In

another example, in 1995

Suharato announced that he

had decided to build a national

car, and that the car would be

built by a company owned by

Mr Hutomo, in association withKia motors of South Korea. To



support the venture, a

consortium of Indonesian banks

was "ordered" by the

Government to offer almost

$700 million in start-up loansto the company.

In sum, by the mid 1990s SE

Asia was in the grips of an

unprecedented investment boom,

much of it financed with borrowed

money . Between 1990 and 1995

gross domestic investment grew

by 16.3% per annum in

Indonesia, 16% per annum in

Malaysia, 15.3% in Thailand,

and 7.2% per annum in South

Korea. By comparison,

investment grew by 4.1% per

annum over the same period in

the US, and 0.8% per annum in

all high income economies.

Moreover, the rate of

investment accelerated in 1996.

In Malaysia, for example,spending on investment

accounted for a remarkable

43% of GDP in 1996.

Excess Capacity. As might be

expected, as the volume of

investments ballooned during

the 1990s, often at the bequest

of national governments, so the

quality of many of these

investments declined

significantly. All too often, the

investments were made on the

basis of projections about future

demand conditions that were

unrealistic. The result was the

emergence of significant excess

capacity.

A case in point were

investments made by Koreanchaebol in semi-conductor



factories. Investments in such

facilities surged in 1994 and

1995 when a temporary global

shortage of Dynamic Random

Access Memory chips (DRAMs)led to sharp price increases for

this product. However, by 1996

supply shortages had

disappeared and excess capacity

was beginning to make itself

felt, just as the Koreans started

to bring new DRAM factories on

stream. The results were

predictable; prices for DRAMs

plunged through the floor and

the earnings of Korean DRAM

manufacturers fell by 90%,

which meant it was extremely

difficult for them to make

scheduled payments on the debt

they had taken on to build the

extra capacity in the first place.

In another example, a building

boom in Thailand resulted inthe emergence of excess

capacity in residential and

commercial property. By early

1997 it was estimated that there

were 365,000 apartment units

unoccupied in Bangkok. With

another 100,000 units scheduled

to be completed in 1997, it was

clear that years of excess

demand in the Thai property

market had been replaced by

excess supply. By one estimate,

by 1997 Bangkok’s building

boom had produced enough

excess space to meet its

residential and commercial

need for at least five years.

The Debt Bomb. By early 1997

what was happening in theKorean semi-conductor industry





the mid 1990s although exports

were still expanding across the

region, so were imports. The

investments in infrastructure,

industrial capacity, andcommercial real estate were

sucking in foreign goods at

unprecedented rates. To build

infra-structure, factories, and

office buildings, SE Asian

countries were purchasing

capital equipment and

materials from America,

Europe, and Japan. Boeing and

Airbus were crowing about the

number of commercial jet

aircraft they were selling to

Asian airlines. Semi-conductor

equipment companies such as

Applied Materials and Lam

Materials were boasting about

the huge orders they were

receiving from Asia. Motorola,

Nokia, and Ericsson were fallingover themselves to sell wireless

telecommunications equipment

to Asian nations. And

companies selling electric

power generation equipment

such as ABB and General

Electric were booking record

orders across the region.

Reflecting growing imports,

many SE Asian states saw the

current account of their Balance

of Payments shift strongly into

the red during the mid 1990s.

By 1995 Indonesia was running

a current account deficit that

was equivalent to 3.5% of its

Gross Domestic Product (GDP),

Malaysia’s was 5.9%, and

Thailand’s was 8.1%. With

deficits like these starting to pile



up, it was becoming

increasingly difficult for the

governments of these countries

to maintain the peg of their

currencies against the US dollar.If that peg could not be held, the

local currency value of dollar

dominated debt would increase,

raising the specter of large scale

default on debt service

payments. The scene was now

set for a potentially rapid

economic meltdown.

Meltdown in Thailand

The Asian meltdown began on

February 5 th, 1997 in Thailand.

That was the date that

Somprasong Land, a Thai

property developer, announced

that it had failed to make a

scheduled $3.1 million interest

payment on an $80 billion

eurobond loan, effectively

entering into defaulting.Somprasong Land was the first

victim of speculative

overbuilding in the Bangkok

property market. The Thai stock

market had already declined by

45% since its high in early 1996,

primarily on concerns that

several property companies

might be forced into

bankruptcy. Now one had been.

The stock market fell another

2.7% on the news, but it was

only the beginning.

In the aftermath of

Somprasong’s default it became

clear that not only were several

other property developers

teetering on the brink on

default; so where many of thecountry’s financial institutions



including Finance One, the

country’s largest financial

institution. Finance One had

pioneered a practice that had

become widespread among Thaiinstitutions --- issuing

eurobonds denominated in US

dollars and using the proceeds

to finance lending to the

country’s booming property

developers. In theory, this

practice made sense because

Finance One was able to exploit

the interest rate differential

between dollar denominated

debt and Thai debt (i.e. Finance

One borrowed in US dollars at a

low interest rate, and leant in

Thai Bhat at high interest rates).

The only problem with this

financing strategy was that

when the Thai property market

began to unravel in 1996 and

1997, the property developerscould no longer payback the

cash that they had borrowed

from Finance One. In turn, this

made it difficult for Finance

One to pay back its creditors. As

the effects of over-building

became evident in 1996,

Finance One’s non-performing

loans doubled, then doubled

again in the first quarter of

1997.

In February 1997, trading in the

shares of Finance One was

suspended while the

government tried to arrange for

the troubled company to be

acquired by a small Thai bank,

in a deal sponsored by the Thai

central bank. It didn’t work,

and when trading resumed in



Finance One shares in may they

fell 70% in a single day. By this

time it was clear that bad loans

in the Thai property market

were swelling daily, and hadrisen to over $30 billion.

Finance One was bankrupt and

it was feared that others would

follow.

It was at this point that

currency traders began a

concerted attack on the Thai

currency, the baht. For the

previous 13 years the Thai baht

had been pegged to the US

dollar at an exchange rate of

around $1=Bt25. This peg,

however, had become

increasingly difficult to defend.

Currency traders looking at

Thailand’s growing current

account deficit and dollar

denominated debt burden,

reasoned that demand fordollars in Thailand would rise

while demand for Baht would

fall. (Businesses and financial

institutions would be

exchanging baht for dollars to

service their debt payments and

purchase imports). There were

several attempts to force a

devaluation of the baht in late

1996 and early 1997. These

speculative attacks typical

involved traders selling Baht

short in order to profit from a

future decline in the value of

the baht against the dollar. In

this context, short selling

involves a currency trader

borrowing baht from a

financial institution andimmediately reselling those baht



in the foreign exchange market

for dollars. The theory here is

that if the value of the baht

subsequently falls against the

dollar, then when the trader hasto buy the baht back to repay

the financial institution it will

cost her less dollars than she

received from the initial sale of

baht. For example, a trader

might borrow Bt100 from a

bank for a period of six months.

The trader then exchanges the

Bt100 for $4 (at an exchange

rate of $1=Bt25). If the

exchange rate subsequently

declines to $1=Bt50 it will only

cost the trader $2 to repurchase

the Bt100 in six months and pay

back the bank, leaving the

trader with a 100% profit! Of

course, since short selling

involves selling Baht for dollars,

if enough traders engage in thispractice, it can become a self-

fulfilling prophecy!

In May 1997 short sellers were

swarming over the Thai baht. In

an attempt to defend the peg,

the Thai government used its

foreign exchange reserves

(which were denominated in US

dollars) to purchase Thai baht.

It cost the Thai government $5

billion to defend the baht,

which reduced its "officially

reported" foreign exchange

reserves to a two-year low of

$33 billion. In addition, the

Thai government raised key

interest rates from 10% to

12.5% to make holding Baht

more attractive, but since thisalso raised corporate borrowing







Indonesian Rupiah that started at about the same time.

Finally, starting in January of 1998, the currencies of all of these countries

regained part of what they had lost since the crises started. It is also important to

note that at a great cost Hong Kong was able to maintain its peg after the crisis

first erupted. This required that interest rates be raised to fend-off these currenciesfrom repeated speculative attacks.

3. The Evolution of Asian Stock Markets During the Asian Financial Crisis

It is necessary to study the evolution of the stock markets and the inflow of

money that went to the Asian economies in order to understand the financial crisis

of 1997- 1998. Net equity investments in the economies of South Korea, Indonesia,

Malaysia, Thailand, and the Philippines amounted to US$ 12.2 billion in 1994, US$

15.5 billion in 1995, US$19.1 billion in 1996, and US$ –4.5 billion in 1997

according to the Institute of International Finance in 1998. The reversal for 1997

came as a result of the financial crisis that started in Thailand, which added

pressure to the currency markets of the countries considered in this article. Net

equity investments and new private loans financed most of the increasing current

account deficits that the SE-Asian economies, as well as most of the developing

world, experienced during the 1990s. The ability of most of the developing world to

import capital through securities markets was enhanced by the exponential growth

in the U.S. mutual fund industry, and the low interest rates available in the U.S.

and Japan during the past decade.

Now, through the following figures, let us turn our attention to the behavior of the

Asian stock market indices during the crisis.

Figures 2A and 2B (above) show the monthly evolution of national stock priceindices (expressed in US dollars) for these same eight countries and during the

same period of time. The stock market indices are those provided by Morgan

Stanley International Capital (MSCI). Figures 3A and 3B (below) show the behavior

of the same Asian stock market indices from January 1997 to May 1998 but

expressed in local currency. As can be seen, the direction of the stock markets is

similar to that of Figures 2A and 2B in which the indices where expressed in US$

terms. However, the magnitude of the decline on the local stock market prices is

not as pronounced when expressed in local currency.

Figures 3A and 3B (above) show the behavior of the same Asian stock market

indices from January 1997 to May 1998 but expressed in local currency. As can be

seen, the direction of the stock markets is similar to that of Figures 2A and 2B in

which the indices where expressed in US$ terms. However, the magnitude of the

decline on the local stock market prices is not as pronounced when expressed in

local currency. This finding suggests the existence of a currency effect affecting

stock price returns during the crises, as is explained in the next paragraph.

The finding of a close relationship between exchange rate depreciations and stock

returns during a crisis is consistent with Bailey, Chan and Chung (2001). These

authors demonstrate, using intraday data, that the severe downturn of the Mexican

stock market in December 1994 and early 1995 can be associated with the Pesodevaluation that took place during this same period. In the case of the five Asian



countries whose currencies experienced the sharpest depreciations during the Asian

crisis (Indonesia, Malaysia, Philippines, South Korea, and Thailand) the average

correlation between weekly stock market returns and currency changes (where

currency is defined as the number of units of foreign currency per 1 U.S. dollar)

between the first week of July 1997 and the first week of May 1998 is –0.63 and issignificant at the 1percent level. My explanation for this strong association is that

currency devaluations have traditionally been accompanied by declining stock

markets in the developing world because they have usually taken place in the

middle of a financial crisis and uncertainty about the future course of economic

policies and outcomes. For instance, the negative impact of devaluing currencies on

S.E.-Asian banks and companies that had borrowed heavily on international

markets most probably surpassed the potential export gains. But an “orderly”

devaluation such as that of Britain in 1992 did not have negative effects on the

London stock market since it helped the British economy recover from a three-year

recession via an export-boom.

4. Were the Stock Markets “Overvalued” Before the Crisis Started?

The stock markets of Hong Kong, Indonesia, and South Korea fluctuated with no

clear trend before the first sub-period of the currency crisis began in early July,

1997. The stock markets of Malaysia, Singapore, the Philippines, and Thailand

drifted downward during this same sub-period, with the later two countries

experiencing the sharpest declines. Finally, Taiwan's stock market drifted upwards

during this same sub-period of time. Therefore, I not see any evidence of a clear

pattern of stock markets collapsing in a contagious fashion before the first round of

devaluations took place in July, 1997, as Krugman (1998) suggested was the case:[4]

And then the bubble burst. The mechanism of crisis, I suggest, involved that

same circular process in reverse: falling asset prices made the insolvency of

intermediaries visible, forcing them to cease operations, leading to further

asset deflation. This circularity, in turn, can explain both the remarkably

severity of the crisis and the apparent vulnerability of the Asian economies to

self-fulfilling crisis –which in turn helps us understand the phenomenon of

contagion between economies with few visible economic links.

I have checked the evolution of the same national stock market indices since 1991

(the preceding five years to the crisis) and, on one hand, I found a significant

increase in Hong Kong’s stock market asset prices (a fourfold increase), while, on

the other hand, the remaining seven stock markets stayed remarkably flat, with

some minor fluctuations. Furthermore, the performance of the Asian stock markets

lagged behind the Latin American, the British, and the United States stock markets

during the same years prior to the crisis. Thus, it seems hard to contend that the

collapse of the stock markets in South East Asia was the result of a bursting

bubble, since the stock prices of the markets of SE-Asia had hardly any growth six

years prior to the currency crises of 1997.

To analyze whether rapidly increasing stock prices represent a bubble; financialeconomists try to express these prices in terms of indicators such as; the earnings



of companies which trade stocks in the market (the P/E or Price/Earnings ratio, and

the P/B or Price/Book ratio.) Rising stock prices and earnings may well yield a flat

P/E ratio (i.e. there is no bubble since higher stock prices are justified by

“fundamentals”, at least as it pertains to the P/E ratio.) For instance, authors like

Gilibert and Steinherr (1996) contend that the rise in stock prices that took place inMexico in the early 1990s was the product of a speculative bubble and that it was

not justified by fundamentals. However, analyzing P/E and P/B ratios of Asian stock

markets just before the crisis erupted it is difficult to contend that these markets

were “overvalued” since the ratios were below the world average (See Table 1

above.)

Finally, Table 2 (above) shows that the U.S. stock market had been, on a risk-

adjusted basis, the best market performer during the period 1990-96, followed by

Latin America, U.K., Asia (excluding Hong Kong), and Japan. The fact that S.E.-

Asian markets plummeted after having lagged behind the performance of those of

the rest of the world, and after having remained relatively flat during the 1990s (i.e.

no bubble), is another indication of how severe and dramatic the financial crisis

was.

Krugman’s assertion is nonetheless consistent with the behavior of national stock

prices in South East Asia after the first round of devaluations. Such evolution had

actually preceded the second and more intense wave of devaluations of November

and December of 1997. This is because, as was shown in Figures 2A and 2B

(above), between the first and second round of devaluations the stock markets of

Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and

Thailand experienced sharp declines. Not until the currencies of these countriesstabilized in early 1998 were their stock markets able to reverse the downward

trend in stock prices (except in Indonesia).

In summary, it is difficult to contend that falling stock prices during the Asian

crises were the result of a bubble that was bursting or that Asian stock markets

were “overvalued” before the crisis first erupted.

5. Stock Market Co-Movements: The Channels of Transmission [5]

In this section the literature of the determinants of stock market co-movements is

briefly examined.

Why do stock market co-movements occur? What are the linkages among stock

markets that can explain a crisis such as the Asian? Calvo and Reinhart (1996)

provide a brief summary of the existent explanations in the context of currency

crisis, [6] and in this paper an attempt is made to adapt some of these explanations

to the case of stock market co-movements during periods of financial crises, a sub-

area in this field that has received relatively little attention. [7] Nonetheless, the

inflow of capital to the developing world that took place in the late 1980s and early

1990s was accompanied by an increasing share of portfolio investments as local

stock markets became increasingly open towards foreign investors. Such is the case

for the Latin America countries where this situation is presented more frequently

than in the South Eastern Asia countries.Stock market co-movements can be explained as follows:



The first reason is that stock market co-movements may take place when the

financial markets of two countries are highly integrated so that shocks to the larger

country are transmitted to the smaller ones via assets-trading. An example of this

type of spillover is the integration of the capital markets of Argentina and Uruguay.

As a result of Argentina’s 2001-2002 severe crisis and subsequent external debtdefault and currency devaluation, Uruguay has recently been forced to devalue its

currency.

The second most important reason are the trade partners and bilateral or

multilateral trade arrangements that enhance the possibilities of international

shocks. For instance, when the currency of a country experiences a large real

depreciation, imports from its trading partners fall, and the trade balance of the

country whose currency is devalued deteriorates, thereby setting the stage for the

currencies of its neighbors to suffer speculative attacks if the impact is large

enough. For example, the Brazilian devaluation of 1999 placed great pressure on

Argentina’s currency, Brazil’s most important trading partner.

The third reason (See Chua, 1993.) emphasizes the role of technological factors

on economic growth. Technological spillovers between neighboring countries tend to

occur because ideas and capital flow are faster and easier across neighboring

countries rather than across distant countries. Thus, the economic growth of a

country is affected by the economic growth of its neighbors. I have found a highly

significant and positive regional spillover effect in a number of the South East Asian

countries.

The first three theories or reasons presented above attempt to explain stock

market co-movements as a consequence of economic linkages among countries.These theories are what Forbes and Rigobon (2000 and 2002) might call

interdependence explanations. Nevertheless, the last three theories or reasons,

which are of a contagious nature, deal with the effects of investor’s behavior on

stock markets, the result of which may cause a stock market crisis or exacerbate an

existing one.

The fourth reason, is that spillovers or contagious crises may occur for

institutional reasons according to the theories of Calvo and Reinhart (1996)

theories: [8]

In response to a large adverse shock (such as the Mexican devaluation) [9]

an open-end emerging market mutual fund that is expecting an increasing

amount of redemptions will sell off its equity holdings in several emerging

markets in an effort to raise cash. However, given the illiquidity that

characterizes most emerging markets, the sell-off by a few large investors will

drive stock prices lower. Hence, the initial adverse shock to a single country

gets transmitted to a wider set of countries.

The fifth reason is that investor’s sentiments can generate self-fulfilling crises if

foreign investors do not discriminate among different macroeconomic fundamentals

across countries. There exists a vast literature on banking and financial crises in the

developed world in which the issue of contagion effects arise frequently. Accordingto Calvo and Reinhart, for example: [10]



In the wake of a bank failure (particularly a large of prominent bank),

anxious depositors possessing imperfect information about the soundness of

other banks rush to withdraw their deposits from the banking system at large.

The stampede by depositors generates a liquidity crisis that spreads to other

healthy banks. Thus, herding behavior by depositors alters the "fundamentals"for a broader set of financial institutions and the crisis becomes self-

fulfilling...A similar story can be told about investors in international currency

and equity markets...With regards to emerging markets, however, relatively

little is known about these issues.

The sixth reason is that contagion may occur because of the way market

participants interpret possible co-movements in macroeconomic policies and

fundamentals in the economies subject to attack. [ Eichengreen, Rose, and Wyplosz

(1996) ]

Given the experience of currency crisis being accompanied by stock market

collapses in the developing world (The figures shown above confirmed this in the

context of the SE-Asian financial crises), a speculative currency attack against one

currency and the concomitant effects may well trigger simultaneous declines in the

stock markets of these same countries.

6. Conclusions

In this paper the currency and stock market collapses experienced by a number of

South East Asian economies in 1997 and mid 1998 have been examined, and the

close relationship between the behavior of their stock markets during this period and

the evolution of the currencies of the countries involved was analyzed. Shown was

that the severe downturn of the Asian stock markets during the financial crisis canbe associated with the currency devaluations of the five countries whose currencies

experienced the sharpest depreciations during the crises, especially in the case of

Indonesia, Malaysia, Philippines, South Korea, and Thailand. This was reflected in an

average correlation between weekly stock market returns and currency depreciations

of –0.63 during the crisis period.

When the evolution of South East Asian stock markets prior to the crisis was

analyzed there was no evidence found of a clear pattern of stock markets collapsing

in a contagious fashion before the first round of devaluations took place in July,

1997 as Krugman (1998) suggested was the case. Krugman’s assertion is

nonetheless consistent with the behavior of national stock prices in South East Asia

after the first round of devaluations occurred. Also, the fact that South East Asian

stock markets plummeted after having lagged behind the performance of those of

the rest of the world, and after having remained relatively flat during the 1990s (i.e.

no bubble), is another indication of how severe the financial crisis was.

Stock market co-movements may occur for different reasons. First, they may take

place when the financial markets of two countries are highly integrated so that

shocks to the larger country are transmitted to the smaller ones via assets-trading.

Second, trade partners and bilateral or multilateral trade agreements enhance the

transmission of shocks internationally. Third, spillover effects may be the result oftechnological factors or economic growth. Fourth, contagious crisis may occur for



institutional reasons. Fifth, investor’s sentiment can generate self-fulfilling

contagious crisis if foreign investors do not discriminate among different

macroeconomic fundamentals across countries. And sixth, contagion may occur

because of the way market participants interpret possible co-movements in

macroeconomic policies and fundamentals in the economies subject to attack.Even though I did not test any of the theories of contagion in this article, I am

inclined to think that “competitive” devaluations were present during the crisis and

that a domino effect was created when international mutual funds sold Asian stocks

and bonds of both crisis and non-crisis countries in an effort to raise cash. These

two channels of transmission correspond to the second and fourth theories of

contagion outlined in the previous paragraph.

Finally, I conclude that contagion or interdependence across stock market returns

diminishes greatly the advantages of international diversification highlighting the

instability of historical correlation coefficients among stock market indices when a

crisis occurs.

References

Bailey, W., Chan, K., and P. Chung, “Depositary Receipts, Country Funds, and the

Peso Crash: The Intraday Evidence,” The Journal of Finance , (Dec. 2002), v55, n6,

pp. 2693-2717.

Calvo, S., and C. Reinhart; “Capital Flows to Latin America: Is There Evidence of

Contagion Effects,” in Calvo, Goldstein, and Hochreiter, Private Capital Flows to

Emerging Markets after the Mexican Crisis (Vienna: IIE, 1996.)

Chua, H.; “Regional Spillovers and Economic Growth,” Center Discussion Paper No.

700. New Haven, CT: Yale University Economic Growth Center.Eichengreen, B., Rose, A., and Ch. Wyplosz; “

The Asian Crisis: Causes and Cures

IMF Staff

The financial crisis that struck many Asian countries in late 1997

did so with an unexpected severity. What went wrong? How can

the effects of the crisis be mitigated? And what steps can be taken

to prevent such crises from recurring in the future?

THE EAST ASIAN countries at the center of the recent crisis were

for years admired as some of the most successful emerging

market economies, owing to their rapid growth and the striking

gains in their populations' living standards. With their generally

prudent fiscal policies and high rates of private saving, theywere widely seen as models for many other countries. No one



could have foreseen that these countries could suddenly become

embroiled in one of the worst financial crises of the postwar

period.

What went wrong? Were these countries the victims of their own

success? This certainly seems to have been part of the answer.Their very success led foreign investors to underestimate their

underlying economic weaknesses. Partly because of the large-

scale financial inflows that their economic success encouraged,

there were also increased demands on policies and institutions,

especially those safeguarding the financial sector; and policies

and institutions failed to keep pace with these demands (see

table). Only as the crisis deepened were the fundamental policy

shortcomings and their ramifications fully revealed. Also, past

successes may have led policymakers to deny the need for action

when problems first appeared.

Net capital flows

(billion dollars)

1994 1995 1996 1997 1998 1999

Total

Net private capital

flows 1

Net direct investment

Net portfolio investment

Other net investmentNet official flows

Change in reserves 2

160.5

84.3

87.8

-11.7

-2.5

-77 .2

192.0

96.0

23.5

72.5

34.9

-120 .5

240.8

114.9

49.7

76.2

-9.7-11 5.9



173.7

138.2

42.9

-7.3

29.0-54 .7

122.0

119.6

18.0

-15.6

37.0

-6 7.1

196.4

119.7

34.4

42.3

-8.9

-91 .1

Developing countries

Net private capital

flows 1





136.6

75.4

85.0

-23.8

9.1

-42. 4

156.1

84.3

20.6

51.2

27.4

-65. 6

207.9

105.0

42.9

60.0

-3.4-10 3.4



154.7

119.4

40.6

-5.3

17.5-55 .2

99.5

99.1

19.4

-19.0

28.6

-37. 3

168.6

99.1

32.2

37.3

5.7

-80.8

Asia

Net private capital

flows 1





63.1

43.4

11.3

8.3

6.2

-39.7

91.8

49.7

10.8

31.3

5.1

-29.0< BR>

102.2

58.5

10.2

33.5

9.3-48.9





economic fundamentals; and

problems of governance and political uncertainties,

which worsened the crisis of confidence, fueled the

reluctance of foreign creditors to roll over short-term

loans, and led to downward pressures on currenciesand stock markets.

External factors also played a role, and many foreign

investors suffered substantial losses:

international investors had underestimated the risks as

they searched for higher yields at a time when

investment opportunities appeared less profitable in

Europe and Japan, owing to their sluggish economic

growth and low interest rates;

since several exchange rates in East Asia were pegged to

the U.S. dollar, wide swings in the dollar/yen exchange

rate contributed to the buildup in the crisis through

shifts in international competitiveness that proved to

be unsustainable (in particular, the appreciation of the

U.S. dollar from mid-1995, especially against the yen,

and the associated losses of competitiveness in

countries with dollar-pegged currencies, contributed to

their export slowdowns in 1996–97 and wider external

imbalances) (see chart);

international investors—

mainly commercial andinvestment banks—may, in some cases, have

contributed, along with domestic investors and

residents seeking to hedge their foreign currency

exposures, to the downward pressure on currencies.

To contain the economic damage caused by the crisis, the

affected countries introduced corrective measures. In the latter

part of 1997 and early 1998, the IMF provided $36 billion to

support reform programs in the three worst-hit countries—

Indonesia, Korea, and Thailand. The IMF gave this financial

support as part of international support packages totaling almost

$100 billion. In these three countries, unfortunately, the

authorities' initial hesitation in introducing reforms and in

taking other measures to restore confidence led to a worsening

of the crisis by causing declines in currency and stock markets

that were greater than a reasonable assessment of economic

fundamentals might have justified. This overshooting in

financial markets worsened the panic and added to difficulties

in both the corporate and financial sectors. In particular, the

domestic currency value of foreign debt rose sharply. Whileuncertainties persisted longer in Indonesia, strengthened



commitments were made elsewhere to carry out adjustment

reforms.

Appropriate strategies

The strategies needed to restore confidence and support a

resumption of growth include a range of measures, tailored totackle the particular weaknesses of each country. These

strategies are the basic ingredients of the IMF-supported

programs in Indonesia, Korea, and Thailand.

Monetary policy must be firm enough to resist excessive

currency depreciation, with its damaging consequences

not only for domestic inflation but also for the balance

sheets of domestic financial institutions and

nonfinancial enterprises with large foreign currency

exposures. As fundamental policy weaknesses are

addressed and confidence is restored, interest rates can

be allowed to return to more normal levels.

Financial sector weaknesses are at the root of the Asian

crisis and require particularly urgent attention. In

many cases, weak but viable financial institutions must

be restructured and recapitalized. Those that are

insolvent need to be closed or absorbed by stronger

institutions.

Governance must be improved in the public and

corporate sectors, and transparency and accountabilitystrengthened. Many recent difficulties spring from

extensive government intervention in the economy, as

well as widespread political patronage, nepotism, and

lax accounting practices. In order for confidence to be

restored, political leaders must send unambiguous

signals that such abuses will no longer be tolerated.

Fiscal policies will need to focus on reducing countries'

reliance on external savings and take account of the

costs of restructuring and recapitalizing banking

systems. Resources will need to be reallocated from

unproductive public expenditures to those needed to

minimize the social costs of the crisis and strengthen

social safety nets.

Prospects for recovery

In all of the countries at the center of the financial turmoil, its

consequences have taken the form of a substantial shrinkage of

investment and consumption, coupled with a rapid improvement

in trade positions. For 19 98 as a whole, the aggregate current

account of Indonesia, Korea, Malaysia, the Philippines, andThailand is forecast to be $20 billion in surplus, compared with



deficits of $27 billion in 1997 and $54 billion in 1996. This

forced improvement in the external situation will help to offset

declines in domestic demand, but output is expected to stagnate

in Indonesia and Korea, and to fall slightly in Thailand.

There have already been some recoveries of exchange rates andstock markets, and as the needed policies are carried out and

external positions improve, confidence should recover further

during 1998. This will pave the way for a moderate rebound of

growth in 1999 and solid recovery by 2000. The experiences of

Argentina and Mexico following the "tequila crisis" of 1994–95,

as well as the experiences of many other countries in similar

situations, demonstrate that when policymakers are prepared to

address the root causes of a financial crisis, economic recovery

is likely to begin a year or so after a crisis peaks. In the East

Asian case, the severity and importance of the crisis in the

financial sector and other structural weaknesses in the countries

concerned mean that necessary corrective measures are likely to

take longer to implement than in crises that can be resolved

mainly by macroeconomic adjustment. At the same time, the

deep declines that have occurred in currency and financial

markets suggest there is scope for relatively sharp rebounds as

confidence recovers.

Moral hazard

Some commentators have argued that the internationalcommunity's assistance to countries suffering from financial

crises will only encourage more reckless behavior by borrowers,

lenders, and investors—a phenomenon that is known as "moral

hazard." Such moral hazard exists when the provision of

insurance against a risk encourages behavior that makes the risk

more likely to occur. In the case of IMF lending, concern about

moral hazard stems from a perception that such assistance might

weaken policy discipline and encourage investors to take on

greater risks in the belief that they will only partially suffer the

consequences if their investments sour.

In fact, though, one of the fundamental purposes of the IMF is to

limit the economic and social costs of crises. The experience of

the Great Depression taught policymakers that the damage

caused by systemic financial crises can be devastating and can

have a global impact. This justifies a public policy role in

avoiding deep and damaging crises.

Nonetheless, in some instances the fact that IMF financing is

available could increase the incentive for risk-taking by both

potential borrowers and lenders. Policymakers could pursuemore risky policies, knowing that the IMF would be there if their





the real exchange rate has appreciated, the current account

deficit has widened, domestic credit has been growing rapidly,

and asset prices have become inflated. An analysis further

indicates that real appreciation of the domestic currency, an

excessive expansion of domestic credit, and a rapidly rising ratioof broad money to international reserves are signals of

vulnerability to pressures in currency markets. Equity price

declines and deteriorations in the terms of trade can also signal

vulnerability to a crisis, as can a rise in world interest rates.

Indeed, a number of these variables indicated the emergence of

vulnerabilities in the Asian countries most affected by the recent

crisis. Indicators of vulnerability do give false signals, however,

and they cannot predict crises.

A key task for future policymakers is to identify and address

vulnerability before crises erupt. While it may be impossible to

detect and correctly interpret warning signals for all types of

crises early enough, preemptive actions have meant that many

potentially serious crises have been avoided in the past. In some

cases, countries may need to adapt their exchange rate regime.

Such mechanisms as currency pegs and currency unions have

served many countries well and have helped to support their

stabilization efforts. When countries adopt a pegged or fixed-

rate arrangement, a number of preconditions must be met. For

example, the anchor currency and the rate at which the peg isset have to be appropriate and policies must be attuned to

maintaining the rate. For some economies, the balance of costs

and benefits seems to be shifting in favor of greater exchange

rate flexibility, partly in order to avoid the risk that a fixed

exchange rate might lead to excessive foreign currency exposure.

The decision to exit a fixed currency arrangement is difficult,

however, and ideally should be taken in a period of calm.

All countries benefit from access to global capital markets and

from the improvement in resource allocation associated with

market-based competition for financing. Among these benefits is

the competition in domestic financial sectors that the entry of

foreign firms allows. At the same time, there are important

preconditions for an orderly liberalization of capital

movements. These include, above all else, a robust financial

system supported by effective regulation and supervision of

financial institutions. During the transition to an open capital

account regime with a liberalized domestic financial sector,

market-based instruments—such as reserve requirements on

foreign currency deposits and short-term borrowing—

may helpto moderate financial flows. Prudential limits on foreign



Crisis Document

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