The Asian Financial Crisis: How and Why it Happened

The Crisis in Southeast Asia

It was only yesterday when we talked about the "Asian economic miracle." But, as if a big earthquake suddenly hit that region, it's now all gone and replaced by turmoil, confusion, and hardship in many of the Asian economies. What really happened? Why did it happen? How is it going to affect us? 

What is now known as the "Asian financial crisis" started in early July, 1997, when Thailand had to devalue its currency, the baht, about 20% against the US dollar , as a result of intense pressure in the foreign exchange market. Not only currency speculators but also many Thai residents were trying to sell the baht and buy the US dollar, causing and worsening capital flight out of the country, as the Thai government was running out of its foreign reserves and losing market confidence in maintaining the currency value and financial stability. In the process, interest rates were shot up, as the outflow of short-term capital intensified. Then, the previously inflated stock and real estate markets collapsed and that has led to Thailand's worst recession in the postwar period with sharply rising unemployment and business failures.

Once the crisis hit Thailand, it has quickly spread to neighboring countries in the Southeast Asian region. The devaluation of the baht made Thai exports cheaper, pressuring other currencies to follow suit. In particular, Indonesia's rupiah came under vicious attack and had to be devalued by about 90% over the period of just a few months. In the process, again, interest rates were rising sharply, as capital flight from Indonesia was accelerating. The subsequent turmoil in the financial markets and the economy as a whole in Indonesia has been even more severe than that in Thailand, due to a complete collapse in the financial as well as the political system in that country. Eventually, former President Suharto had to resign as a first step towards the restoration of market confidence in the Indonesian government. 

The Asian Contagion and IMF Assistance

In the following round, the currency and financial crisis in Southeast Asia has brought down South Korea, which got into essentially the same trouble as Indonesia and Thailand. The South Korean economy is being hard hit because it has invested heavily in the Southeast Asian countries in general and in Indonesia in particular. In this so-called "Asian contagion" process, South Korea, just like Indonesia and Thailand, has gone almost bankrupt as a nation and is receiving financial assistance from the International Monetary Fund and other major countries. As of mid-1998, the assistance package totals about $55 billion for South Korea, while that for Indonesia is $45 billion and for Thailand $35 billion.

In a sense, economic conditions in those Asian countries which are assisted by the IMF have been worsening, rather than improving, because of the IMF's stringent terms for such assistance---keeping high interest rates while cutting public spending and raising taxes. Those measures may have helped reestablish fiscal and monetary discipline and thus avoid another round of currency devaluations and further contagion, but most likely have a deflationary impact on the already depressed economy in each country. So, the worst may not be over yet. 

In the meantime, the Asian economic "earthquake" has been sending its shock waves around the world. Probably the hardest hit are some of the emerging market economies such as Russia, Eastern Europe, and Latin America, which depended heavily on the Asian economy in terms of trade and investment.

So far, the US economy has escaped a detrimental effect of the Asian aftershocks, except some manufacturing sectors whose exports to Asia have declined sharply in the last few months. American consumers are by and large benefiting from cheaper import prices and lower interest rates for now. But no one is sure what its total impact on the US will be in the future, especially if the Asian crisis enters into another round of devaluations, sending both China and Japan into financial chaos.

Main Causes for the Asian Crisis

It is important to find out why the crisis hit Asia in order for us to come up with any cure for the illness. There seem to be several factors causing and worsening the crisis in Asia. 

First of all, there are obviously some currency factors. It is early to blame currency speculators for a market-induced devaluation. However, it became clear already by the end of 1996 that all of the Southeast Asian currencies were overvalued, as they were pegged to the rapidly appreciating US dollar against the Japanese yen and the Chinese yuan in 1995-96. In particular, the Thai baht which was first hit by speculation in the current crisis had been almost completely pegged to the dollar for more than 10 years! So, it was time for its devaluation anyway.

Second, there are some financial factors, which can explain why those Asian governments kept the pegged exchange-rate regime so long, and also why the markets reacted so drastically--overreacted in some cases. In the last several years, many of the Asian countries have been trying to attract short-term capital money from abroad to finance growing credit demand at home. This is the main reason why the governments were so reluctant to devalue their currencies for the benefit of foreign investors, and were so willing to liberalize their financial system without implementing reasonable rules and regulations on financial institutions. As a result, their financial system as a whole became so vulnerable, and once it was attacked by speculators, there was a massive outflow of short-term capital from the system, leading to the market overreaction.

Third, there are macroeconomic, fundamental factors. With overly ambitious development targets pursued by the governments, many of the Asian economies were overheating with high inflation rates and large trade deficits, contributing to heavy external borrowing and currency overvaluation. Their stock and real estate values were inflated too much and ready to collapse at any moment. In any event, their growth expectations were too high and had to be adjusted to a sustainable level.

Fourth, there are political and structural factors. In the process of economic development in Asia, many of the political leaders became de-facto dictators, based on their antiquated political systems with special privileges for their inner circle and widespread corruption in key government sectors. All this amounted to inflexibility in adjusting growth targets and in dealing with crisis situations, leading to the loss of market confidence in the whole system. Therefore, new political leaders should emerge as a step towards necessary structural reforms in Asia.

Finally, one might add the IMF factor. While the IMF has extended its assistance in an attempt to help ease the Asian crisis and to restore some confidence in the markets, there is much criticism of the IMF's remedies for the crisis. Especially, many government officials in Asia along with some Western economists are critical of the restrictive rules and conditions attached to the IMF's aid packages; tight fiscal and monetary policies, together with structural reforms, forced by the IMF, might well make the already depressed economy even worse. Others insist that the IMF-led rescue packages have bailed out many investors and thereby prompted more risk-taking behavior, leading to the worsening of the financial crisis in Asia. The question is whether the IMF is part of the solution or part of the problem itself. 

REFERENCES

1. Yahoo, Search for Asian Crisis ---- http://search.yahoo.com/bin/search?p=asian+crisis

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3. Lycos, Search for Asian Crisis ---- http://www.lycos.com/cgi-bin/pursuit?machimode=and&cat=lycos&query=asian+crisis

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Morris Goldstein "The Asian Financial Crisis" ---- http://www.iie.com/news98-1.htm

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Morris Goldstein "The Asian Financial Crisis: Causes, Cures and Systmic Implications"
(ISBN paper 0-88132-261-X) ---- http://www.iie.com/pa55.htm

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8. Martin Feldstein, "Refocusing the IMF," Foreign Affairs, March/April 1998

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