ETHOS Issue 03, Oct 2007
The 1997/98 Asian Financial Crisis hit the fastest growing economies in the world, and prompted the largest financial bailouts by international financial institutions (IFIs) in history. It brought to an end decades of strong economic growth among Asian economies that were previously lauded for their sound economic policies of export orientation, balanced budgets, and high savings and investment rates.
Beginning in Thailand and spreading to Indonesia, South Korea, Malaysia and the Philippines, the contagion effects of the crisis were felt as far as Russia and Brazil. It dealt a sharp blow to fragile and over-extended banking systems, resulted in a severe tightening of credit in the Asian economies, forced a sharp depreciation of all their currencies, and led to a major economic contraction in Asia.
THE ORIGINS OF THE CRISIS
The essence of the crisis was a huge, sudden reversal of capital flows. Asian economies that were previously attracting large amounts of foreign capital suddenly experienced withdrawals of short-term lines of capital, an exodus of portfolio investments, and capital flight by domestic investors. Net capital inflows of US$93 billion into the five most affected Asian economies (South Korea, Indonesia, Thailand, Malaysia and the Philippines: the Asian-5) in 1996 were suddenly replaced by a net capital outflow of US$12 billion in the second half of 1997. Most of the turnaround arose from a US$73 billion reversal in net bank lending flows, with the sharpest outflows recorded in Thailand and Korea of some US$18 billion each.1
During and immediately after the crisis, much of the debate among economists centred on whether the Asian crisis was caused by weak economic and financial fundamentals, or by financial panic unrelated to economic conditions. Certainly, most of the macroeconomic indicators of financial stability gave little reason to expect a major crisis in any of the affected countries at the time. Budgets were generally in balance or showing surpluses. By emerging country standards, inflation rates were relatively low (below 10%), and stable or declining. Savings and investment rates were high and generally rising prior to the crisis.2 Indeed, the crisis was largely unanticipated because the economies were pursuing the export-led model of growth that had sustained the Asian economic miracle of the preceding two decades. Confidence was buttressed by the glowing reviews these economies received in various World Bank and Asian Development Bank reports, and in International Monetary Fund (IMF) assessments.
Ironically, the optimism of the IFIs had helped to create a general bullishness among governments, investors and borrowers in the long-term economic prospects of the East Asian economies, obscuring serious microeconomic problems that beset their corporate and financial sectors. These included a legacy of bad lending and investment practices fostered by a climate of relationship-based lending; disincentives to monitor risk due to the implicit guarantee of government bailouts; and inadequate supervision and regulation of domestic financial institutions. These vulnerabilities, combined with financial sector liberalisation from the 1990s onwards and de facto fixed exchange rate regimes, led to increasing exposures to credit risks and ever more fragile financial systems. Bank claims on the private sector grew exponentially in the years leading up to the crisis.3
The abundance of inexpensive capital from abroad, combined with lending based on non-economic considerations, led to a misallocation of capital into speculative and uncompetitive ventures, particularly in real estate and equity markets. Even before the crisis struck, bank and non-bank balance sheets were already deteriorating as the quality of investments in the Asian-5 countries declined and the proportion of non- performing loans increased substantially.
FINANCIAL PANIC AND THE SPREAD OF THE CRISIS
In 1996 and early 1997, the asset bubble created by cheap foreign capital and excessive lending began to burst in some countries, notably Thailand and Korea, where stock market and real estate prices fell sharply. The emergence of wide losses and defaults in the corporate sector also highlighted the low profitability of past investment projects. This led to a massive capital withdrawal, although the immediate triggers differed from country to country.
Once the bubble bursts, panic in financial markets played a key role in explaining why the crisis was more severe than weak fundamentals alone might suggest. Domestic investors began to look more critically at weaknesses that had been previously ignored; new information in an environment with poor disclosure further amplified concerns about the quality of investments, the size of foreign borrowings, and the stability of the financial system. As the crisis expanded, domestic residents became less willing to hold assets in domestic financial institutions and foreign creditors became less willing to roll over their loans, causing a liquidity squeeze that led to the bankruptcy of financial institutions as well as private firms that had borrowed from them. Thus the initial loss of confidence turned into a self-reinforcing creditors’ panic.
Panic in financial markets explains why the crisis was more severe than weak fundamentals alone might suggest.
In many cases, policy mistakes on the part of Asian governments after the crisis had begun and the political constraints they faced added to the instability and volatility. When their currencies came under attack, the central banks of Thailand, Korea and Malaysia mounted expensive but futile currency defences by intervening in the forward markets. These did little to reduce pressures on their currencies, but shrunk their foreign exchange reserves further, causing already jittery creditors to be even less willing to roll over their loans. In Indonesia, which suffered the sharpest depreciation of its currency (of 81% between June 1997 and January 1998), there was an inherent tension between the vested interests of the Suharto regime and the structural reforms needed to restore market confidence. The Indonesian government’s backtracking on many of the promises it had made under the IMF programmes further undermined the credibility of its commitment to reform.
INTERNATIONAL FINANCIAL INSTITUTIONS: A CASE OF BAD PRESCRIPTIONS?
Much of the subsequent debate on the Asian Financial Crisis has revolved around whether the remedial policy prescriptions of the IFIs were largely correct or made the situation worse. The recurrent theme of the criticisms of the IMF is that it should have concentrated on reassuring markets instead of disciplining countries—for instance, in demanding fiscal austerity from countries that did not have budget problems.4
IMF failed to understand the panic element in the Asian crisis, and that its response should have bene to focus on providing liquidity, aided possibly by temporary capital controls.
Critics of the Fund argue that the IMF failed to understand the panic element in the Asian crisis, and that its response should have been to focus on providing liquidity, aided possibly by temporary capital controls (which the IMF objected to on ideological grounds). Joseph Stiglitz, for instance, argues that the IMF shared a significant part of the blame for the onset of the crisis because it had encouraged capital market liberalisation in emerging economies before their institutional and regulatory capabilities were sufficiently developed to manage the large capital inflows. He further argues that the IMF misdiagnosed the problem and prescribed the same anti-inflationary strategies that it had applied in Latin American crises (which had been caused by profligate government spending and loose monetary policy).5 The problem in Asia was not with the governments’ macroeconomic policies, but the mounting debts of the corporate sector.6 In this context of insufficient (rather than excess) demand, the policy prescriptions of fiscal contraction, tight domestic credit and high interest rates were inappropriate and deepened the downturn.
Other critics such as Jeffrey Sachs have also pointed out the IMF’s “poorly thought-out approach to the banking system” which forced a closure of weak banks without a comprehensive financial restructuring plan or measures to strengthen the rest of the banking system, set off a bank run that undermined the rest of the system, including healthy banks, and increased the costs of the IMF’s tight money policy.7 Others point to the IMF’s imposition of wide-ranging conditions, including those on matters that seemed to have little to do with financial stability, which may have distracted attention from the urgent issues at hand.6
In the IMF’s defence, three arguments must be highlighted. First, it should be emphasised that the root of the crisis was a loss of confidence, arising from underlying structural and financial problems as well as a sudden re-evaluation by investors of the attractiveness of the country as a place to invest. A developing country gripped by financial panic and capital flight “does not have luxury of borrowing more or of cutting interest rates without worsening the panic.”8 To the extent that fiscal probity and tight credit policies were necessary for restoring confidence, it was not a policy choice that the crisis-hit countries could have avoided—even if the tough measures deprived indebted companies and banks of much-needed liquidity.
Second, it should be noted that the hesitation and lack of commitment on the part of governments in many cases were probably more to blame for causing greater market uncertainty than the supposedly intrusive and inappropriate reforms prescribed by the IMF.
Third, the crisis was not just a case of pure panic. Even if panic did amplify the effects of the crisis, there were serious flaws in the Asian economies, especially in their financial systems. The IMF could not have acted simply as a lender of last resort. With its limited resources, “it cannot offer an open-ended credit line to liquidity-constrained countries in the same way that the Federal Reserve can for liquidity-constrained banks”.4
AFTERMATH: POLICY LESSONS FROM THE CRISIS
The Asian crisis raised key questions not just for the economic policies of emerging economies, but also for the role of the IFIs in crisis prevention and crisis management. Nevertheless, calls for their abolition—on the argument that they first caused the crisis and then exacerbated it—were largely exaggerated and misplaced. In a world characterised by increasing economic interdependence and financial linkages, institutions promoting global governance and economic development ought to be strengthened, not weakened.
There are, however, fundamental questions about the appropriateness of the policy prescriptions of the IFIs, the desirability of the liberalisation policies they advocated, and how the international financial architecture might be reformed. There certainly appears to be the case for the IMF to focus more narrowly on its core mission of financial stability, rather than to spread its energies and resources thinly across a wide range of social and developmental issues. Furthermore, it would be prudent for IFIs to be less ideological and more pragmatic in their policy prescriptions in crisis management even if neo-liberal economic prescriptions are the norm under ordinary circumstances.
The Asian crisis is evidence that economic growth and financial stability are related but separate policy objectives, and that IFIs cannot afford to ignore financial and corporate health and vulnerabilities even if macroeconomic fundamentals appear healthy.
It is also a cautionary tale about financial liberalisation in emerging markets. While the case for liberalising long-term foreign direct investment9 remains sound, the crisis suggests that a more nuanced and sequenced approach to capital market liberalisation, particularly in ensuring that the requisite regulatory institutions are in place, would be more prudent. To a large extent, this lesson has been taken on board by the IFIs. The IMF, for instance, now emphasises the need to build stronger regulatory regimes and financial institutions alongside more open capital markets, reducing the risks of instability.
The crisis made clear the dangers of fixed or semi-fixed exchange rate regimes (or soft pegs). Fixed rates may reduce volatility and uncertainty; they can also be useful in providing a price anchor in high-inflation countries. But because fixed rate regimes do not allow for nominal rate adjustments, they tend to cause currencies to become misaligned (e.g. over-valued) with the economy’s fundamentals.
To the extent that the severity of the crisis was in large part due to panic, a key policy thrust of the IFIs must be to improve disclosure and transparency in emerging economies before crises occur. In the Asian economies, poor information environments created uncertainty and led to markets over-reacting and assuming the worst when new information—for example, concerning the strength of a particular bank—was revealed. Such over-reactions are less likely if banks, financial institutions and governments comply with international and stricter codes and standards on financial, statistical and fiscal reporting.
The Asian crisis is evidence that economic growth and financial stability are related but separate policy objectives.
The Asian crisis also demonstrated the need for market-based mechanisms that could facilitate more orderly private debt workouts. The complication with the Asian crisis was that it involved a large number of private-sector debtors, rather than a sovereign debtor. This calls for a debt restructuring mechanism that would impose a generalised standstill on a country’s debt servicing obligations, in tandem with bringing together debtors and creditors for collective rollovers and debt renegotiation. This would have reduced the need for costly IMF bailouts and a reduction in the moral hazard created by these bailouts. Investors and creditors would also exercise greater due diligence and focus appropriately on risk in good times, since they would have to bear the consequences of their decisions. One market-based alternative that has been taken up by some emerging economies is to set collective action clauses in bond issues, requiring investors to authorise a third party to represent their collective interests in the event of default.
Finally, the crisis revealed the need for stronger social safety nets in most emerging economies. Strengthening governments’ capabilities to sustain essential social services to the most vulnerable segments of their populations should become a priority area for development lending and assistance. This in turn requires institutions such as the World Bank and regional development banks to develop the expertise in fiscally sustainable unemployment insurance/assistance programmes that do not undermine work incentives. In many emerging economies, families and local communities have tended to play a bigger role than the state in delivering such assistance. In this context, the IFIs should look to strengthen and build on these existing structures rather than require governments to supplant these traditional institutions of providing assistance.
- Staff team led by Charles Adams, Donald J. Mathieson, Garry Schinasi, and Bankim Chadha, “The Asian Crisis: Capital Markets Dynamics and Spillover,” in International Capital Markets: Developments, Prospects, and Key Policy Issues (Washington, D.C.: International Monetary Fund), 13.
- Glick, Reuven, Thoughts on the Origins of the Asian Crisis: Impulses and Propagation, Pacific Basin Working Paper Series PB98-07 (San Francisco: Federal Reserve Bank of San Francisco, September 1998), 3.
- Between 1990 and 1996, the ratio of bank lending to GDP, grew by 60% or more in Thailand (from 64% to 102% of GDP) and the Philippines (from 19% to 49% of GDP), 30% in Malaysia (from 71% to 93% of GDP), and 10% in Korea (from 52% to 62% of GDP) and Indonesia (from 46% to 55%). In Indonesia, modest bank lending to the private sector masked high levels of direct foreign borrowing by private firms.
- Krugman, Paul, Will Asia Bounce Bank, Speech for Credit Suisse First Boston, Hong Kong, March 1998.
- Stiglitz, Joseph, Globalization and Its Discontents (USA: W. W. Norton & Company, Inc., 2002), 104
- Feldstein, Martin, “Refocusing the IMF”, Foreign Affairs, March/April 1998.
- Radelet, Steven, and Sachs, Jeffrey, “What Have We Learned, So Far, from the Asian Financial Crisis?” Mimeo, Harvard Institute for International Development, January 1999.
- Rubin, Robert E., and Weisburg, Jacob, In an Uncertain World: Tough Choices from Wall Street to Washington (USA: Random House, 2003), 258.
- Foreign direct investment levels to the Asian-5 countries remained relatively stable throughout the crisis.