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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
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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.
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(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
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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
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(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
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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
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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
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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
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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
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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
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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
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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,
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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
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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,
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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
$68 billion) in bad loans or about 20% of all the loans they had issued. Overdue loans were 11.3%,
idle loans
7.7% and uncollectible loans 1.3%. These accounted for 90% of the officially recognized badloans in the
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economies
and Germany 33.6%. Table 2. International Claims (Loans) by Banks in Selected Developed
Nations on
Borrowers in Troubled Asian Economies December 31, 1996 ($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
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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
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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
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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
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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: .
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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.
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
$33 billion. In addition, the
Thai government raised key
interest rates from 10% to
12.5% to make holding Baht
more attractive, but since thisalso raised corporate borrowing
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Indonesian Rupiah that started at about the same time.
Finally, starting in January of 1998, the currencies of all of these countries
regained part of what they had lost since the crises started. It is also important to
note that at a great cost Hong Kong was able to maintain its peg after the crisis
first erupted. This required that interest rates be raised to fend-off these currenciesfrom repeated speculative attacks.
3. The Evolution of Asian Stock Markets During the Asian Financial Crisis
It is necessary to study the evolution of the stock markets and the inflow of
money that went to the Asian economies in order to understand the financial crisis
of 1997- 1998. Net equity investments in the economies of South Korea, Indonesia,
Malaysia, Thailand, and the Philippines amounted to US$ 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
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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
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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:
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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]
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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
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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
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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
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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
Net direct investment
Net portfolio investment
Other net investmentNet official flows
Change in reserves 2
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
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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
Net direct investment
Net portfolio investment
Other net investmentNet official flows
Change in reserves 2
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
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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
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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
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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
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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