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The East-Asian Crisis

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Submitted By cvaditya
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Introduction: The East Asian crisis was a period of financial crisis that gripped much of Asia which beginning in July 1997 and raised fears of worldwide economic meltdown due to financial contagion.1 Several countries such as Malaysia, Thailand, Indonesia, the republic of Korea and the Philippines were hit directly while others such as Taiwan province of China, Singapore and especially Hong Kong, China were badly affected. What began as a speculative attack on the Thai baht in July 1997 quickly spread as ‘contagion’ to the other countries. Over a three-month period between July and October 1997, the baht fell nearly 40 per cent, the Malaysian ringgit and Philippine peso by about 27 per cent, the Indonesian rupiah by about 40 per cent and the Korean won approximately 35 per cent against the United States dollar. For countries that had been dubbed “miracle economies” this was a serious blow with wide-ranging economic, social and political ramifications.2 In this paper we would try to undertake an empirical analysis of the factors leading to the crisis by analysing on two major points: 1) How have these countries performed in the years leading to the crisis? 2) What was the policy response to the currency crisis and what similarities/differences were there in policy responses across countries? We try to do this by analysing the macroeconomic data of three countries, Malaysia, Thailand and the Republic of Korea, over a 13-year period, from 1990 to 2002. The 13-year period is divided into three time segments. The period 1990-1996 is the pre-crisis period, 1997 and 1998 is considered the period of the crisis and 1999-2003, is the period of recovery. Pre-crisis period: The pre-crisis period could be explained by four different theories: 1) Existence of structural weakness and policy distortions 2) Moral hazard 3) Self fulfilling panics 4) Temporary illiquidity Existence of structural weakness and policy distortions:
1 2 Lessons from East Asia crisis and recovery “Obiyathulla Ismath Bacha”

Very high levels of debt financed by commercial banks on variable interest rates, sharp reductions in FDI inflows and overvalued exchange rates are common features of crisis hit countries. Since an exchange rate regime is ultimately determined by the Government, overvaluations are nothing but purely policy induced distortions. Moral hazard: Moral hazard arising from the existence of either actual or implicit guarantees can be put forth as yet another explanation. Herding and self fulfilling panics: Herding leads to self-fulfilling panics because rational investors would want to pull out their money if they believed other investors would do the same. When all investors hit the exits at the same time, a self-fulfilling crisis begins.3 Illiquidity: When large gaps exist in the stocks of liquid financial assets and gross reserves (in the presence of a pegged exchange rate), vulnerability increases. Given these imbalances, a sudden shock can quickly drain reserves, making the fixed exchange rate unsustainable.

Pre-crisis conditions: Over the seven-year period 1990-1996, all three countries experienced very rapid GDP growth.

Malaysia Thailand Republic of Korea Average

Compounded growth 11.63 11.22 11.7 11.52

annual Cumulative compounded growth 116 110.6 117.6 114.67

Table 1 GDP data of selected East-Asian Countries before the crisis period

The three countries had an average annual growth of 11.52 per cent over the seven-year period. This is indeed an impressive performance by any measure.

Bacha, Obiyathulla, 1998. The Asian currency crisis: a fait accompli? Malaysian Journal of Economic Studies, vol. 34, 1997, Kuala Lumpur.

With cumulative growth above 100 per cent, all three countries had more than doubled their GDP in the seven-year period. It is not surprising, therefore, that these economies were referred to in glowing terms as “miracle economies”. Yet in the following two years, 1997 and 1998, all three countries were in serious trouble. What Went Wrong? To understand what went wrong lies in examining how these GDP growth rates were financed. The growth pump was being primed by three broad means: (a) Rapid monetary growth (b) Large current account deficits and (c) Capital inflows. Rapid monetary growth: Rapid domestic monetary growth appears to be a common feature of all three countries in the pre-crisis period. Real GDP Malaysia Thailand Republic of Korea Average United States 7.33 6.86 6.31 6.8 1.75 M2(Money Supply) 15.5 13.6 14.6 14.6 2.14 Domestic credit 20.1 21.3 17.8 19.7 -

Table 2 Comparison of Money Supply, Domestic Credit with GDP of these countries

We can summarise two things from it. First, money supply, as measured by M2, had grown at more than twice the rate of growth in real GDP. Second, domestic credit had grown approximately at three times the rate for real GDP. Such deviations between real and monetary growth can be harmful when sustained over a period of time. Current account deficits, negative savings-investment gaps: Current account deficits have been pointed out as one of the key reasons for the currency crisis. Notice that all three countries had current account deficits in every one of the seven years before the crisis. In many instances the percentage was larger than the 5 per cent threshold which many would consider a risk level. There are a number of reasons for this consistent deficit. The first reason is the obvious push in all these countries for growth. Rapid

GDP growth requires heavy investment growth. Thus, the import of capital goods increased and import growth outpaced that of exports in several years.

Capital inflows- reliance on short term inflows: The flip side of a current account deficit is a capital account surplus. Holding reserves constant, a current account deficit must be matched by a capital account surplus. As such, all our crisis countries have had capital account surpluses, meaning strong capital inflows. Large capital inflows in themselves are not a problem. It is the form and composition of the inflows that really matters. Inflows in the form of FDI are long term in nature and add to productive capacity. However, inflows in the form of portfolio investments or short-term deposits/ borrowing can be destabilizing. Though FDI inflows still constituted a major portion, short-term inflows in the form of portfolio investments and borrowing were increasing.4 Short-term loans Foreign loan as percentage Short term of reserves loan as percentage of loans 181 118 300 202.5 83.90 46.9

Thailand Republic Korea Malaysia

45 733 of 67 468 12 451

Table 3 Capital Inflows data of these countries

Crisis period 1997-1998: The catalyst that led from vulnerability to full-blown crisis was the speculative attack on the Thai baht in July 1997. The initial attack worsened and spread as contagion to the other East Asian countries when it was revealed that the Thai central bank’s level of usable reserves was much less than what had been originally reported. The speculative attack itself was not new. These same currencies had come under a similar attack in early 1995 following the Mexican peso crisis. Whereas they had successfully defended their currencies in 1995, this time it was different. What was different this time was the massive capital outflow. With hindsight, it now appears that, more than the speculative attack; it was indeed the capital outflow that led to a full-blown crisis. The massive

Asian Development Bank, 2003. Asia Economic Monitor 2003, July 2003 update.

capital flight was probably the reaction to the vulnerabilities that had been building up and now lay bare by depreciating currencies. Three things worked against the central banks in their efforts to stabilize their currencies: capital flight, low reserves and interest rates. Faced with capital outflows that were undermining their currencies and low reserves with which to defend, the central banks had little choice but to float their currencies and raise interest rates to prevent a financial collapse. Given the highly leveraged nature of their domestic economies, raising interest rates was extremely painful and counterproductive in some ways. With depreciating currencies, rising interest rates became the mechanism by which the currency crisis was transmitted into a domestic banking sector crisis. The banking sector in all three countries took a hit. As the corporate/ real sector began to reel under sharply increased interest rates, non-performing loans spiked. The severity of the crisis is evident from the GDP growth numbers. All three countries experienced a sharp contraction in growth over both years, particularly in 1998. Average GDP growth for the three countries was approximately – 8 per cent for 1998, a sharp contrast to the 11.5 per cent average for the seven-year crisis. The sharp fall in GDP growth was due to a significant reduction in consumption expenditure (especially in public consumption) and in gross domestic investment (GDI). GDI deteriorated an average of 40 per cent in 1998. The sharply contractionary policies, both fiscal and monetary, were aimed at currency stabilization and restoring confidence. All three countries show negative balances for both years, implying net capital outflows.5 Lessons for Crisis prevention: Each major economic crisis re-energizes academic literature on the subject of crisis. Figure 1 shows the number of academic publications and working papers on international crises from 1985 to 2009. The literature during this period focused on crisis prevention and management, and aimed at drawing lessons that would help avoid or soften the effects of similar crises in the future. The goals of such research were, first, to improve the models designed to predict

Frankel, J. and A.K. Kose, 1996. “Currency crashes in emerging markets: an empirical treatment”, Journal of International Economics (41), pp. 351-366.

imminent crises, and, second, to develop policies to minimize losses, speed up recovery, and minimize the susceptibility of a country to crisis, whether it originates internally or spreads through financial and goods markets.

The Asian financial crisis came as a surprise to policymakers, investors, and academics. Yet, many agreed not only that the crisis could have been expected, but also that, to a great extent, it might have been avoided. Investors and policymakers missed some warning signs of unsustainable lending booms, such as high corporate debt-to-equity ratios:  In 1996, those ratios were respectively 310% in Indonesia and 518% in Korea (Debt-to-equity ratios).  High ratios of short-term debt to central bank reserves, an important measure of a country’s overall external foreign currency liquidity, were another red flag. In 1996, this ratio was 177% in Indonesia and 193% in Korea (short-term debt to central bank reserves). However, some symptoms common in previous crises, such as excessive current account and budget deficits, were missing. Importantly, prior to the Asian financial crisis, early warning systems focused on government external finances and ignored private debt stocks that could become public liabilities because of implicit guarantees. For these reasons, the early warning systems did not sound alarms. Economists formulated a number of policy recommendations aimed at preventing a repetition of Asian flu-type crises:  Bank regulators were encouraged to require greater transparency and supervise lending activity more strictly, paying particular attention to currency and maturity mismatches.  Some scholars urged that highly leveraged institutions be required to improve risk assessment and reduce leverage ratios.

 Some, seeing what Chinese did, argued for capital controls to lengthen the maturity and alter the composition of foreign capital inflows so that more investment came in as equity and less as debt. An international lender of last resort was needed to resolve crises, economists said, questioning whether the IMF could fulfil this role given its limited funds.  Economists also called for private-sector contingent credit lines to manage liquidity problems. Private-sector involvement in crisis resolution was held to be vital, given the enormous volume of international capital flows. Conclusively, the differences between the economies and financial systems of East Asia in 1997 and the United States and Western Europe in 2007 were genuine and important. Developed world financial markets were more mature, more sophisticated, and better supervised than markets in East Asia. Yet, despite these differences, the developed world also turned out to be vulnerable to financial crisis. Global financial integration increased dramatically in the decade preceding the 2007–09 crisis, creating channels for the rapid spread of financial contagion throughout the developed world. Lessons learned from the Asian financial crisis of 1997–98, such as the dangers of high leverage ratios and credit growth, appear to be similar to the ones that emerged in the post-2007–09 policy debate. However, differences in economic development and sophistication of the financial systems of East Asian countries compared with those of the United States and Western Europe led policymakers in the advanced economies to believe that the lessons of the earlier crisis did not apply to them. Moreover, it turned out that mature financial markets were not as resilient to shocks as we thought they were prior to 2007.i

REFERENCES: i Could We Have Learned from the Asian Financial Crisis of 1997–98? BY GALINA HALE Lessons From East Asia’s Crisis And Recovery - OBIYATHULLA ISMATH BACHA

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