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The East Asian Financial Crisis

A Review

Introduction

Following the devaluation of the Thai baht on July 2, 1997, East Asia suffered a precipitous economic and financial decline of nearly epic proportions. In just over 12 months, the region's stock markets saw their market capitalization shrink by as much as 85%, with some currencies declining by more than 80% vis-à-vis the dollar. As a result, the once mighty economies of East Asia witnessed dramatic downturns, huge drops in asset prices, and rising unemployment. Although the reasons for the East Asian financial crisis are varied and complex, it is widely accepted that excessive capital inflows, lack of adequate banking regulations and monetary instability, as well as a host of policy and institutional failures, all combined to deliver a devastating blow to the region’s financial and economic systems. In an effort to understand the roots of the East Asian crisis, the present analysis will examine the macroeconomic factors leading to the financial meltdown in the region.

Excessive Capital Inflows

The East Asia financial crisis was preceded by a huge infusion of capital, both domestic and international, into the region. Although not considered negative factors per se, the large capital inflows masked underlying problems in East Asian economies, allowing banks to take excessive risks and approve loans that would have been judged imprudent absent the amount of capital in the system. As was the case with the financial situation preceding the great Wall Street Crash of 1929, the system imploded once investors lost confidence and began to call back their loans.

The following factors contributed to the rapid increase in capital inflows:

	Financial deregulation in Europe freed investors to seek better returns in overseas markets, particularly those in Asia.
	Relatively higher returns in the stable economies of East Asia attracted foreign sources of capital.
	Local banks were also attracted to the higher returns and, perhaps unwisely, lent tremendous amounts of capital to East Asian businesses.
	East Asian businesses also sought to reduce their finance costs by borrowing from relatively inexpensive foreign markets, resulting in excessive accumulation of foreign-denominated liabilities.

As the following figure illustrates, the excessive capital inflows united to form a vicious cycle leading to increased instability:

Figure 1 Capital Inflows, Lending Increases, and Weaknesses

Weak Banking Systems

As the International Monetary Fund (IMF) indicated in its 1997 World Economic Outlook, East Asian banking systems were not in a position to resist major economic and monetary shocks:

Limited experience among financial institutions in the pricing and managing of    risk, lack of commercial orientation, poor corporate governance, and lax internal controls, all in the face of movements toward liberalization and increased competitive pressure, had contributed to imprudent lending - including lending associated with relationship banking and corrupt practices.

An aggravating factor was that many East Asian businesses were relying on short-term loans to finance long-term expansion. Once the credit bubble popped and sources of debt financing dried up, many businesses were unable to repay their fixed commitments and either dug themselves deeper into debt with new loans -as did Daewoo- or simply went bankrupt.

Further compounding the problem was the region’s notorious “crony capitalism,” the often cozy relationships between government, major businesses and bankers. Indeed, many view crony capitalism as one of the principal factors behind the rapid success and ultimate collapse of Daewoo, the Korean industrial behemoth. Viewed as instruments of national economic policy, many East Asian banks were required by their governments to extend loans to friendly companies such as Daewoo, even if those companies were financially suspect. Nevertheless, as debt levels continued to spiral to unsupportable levels and economic conditions deteriorated, many businesses were simply unable to repay their loans, resulting in numerous bankruptcies. The following figure illustrates the ridiculously high levels of debt assumed by East Asian countries during the 1990s:

The high debt levels, combined with a slew of currency devaluations, triggered a massive panic by foreign investors, who quickly sold off their stocks and bonds. Much like the Internet crisis of the late 1990s, once the herd mentality switched direction, everyone pulled out of the market in a mad rush to protect valuable investments.

Monetary Instability

The actual trigger of the East Asian financial crisis was the decision by Thailand to abandon pegging its currency, the baht, to the US dollar. Once that occurred, the baht quickly tumbled, bringing down with it the Malaysian ringgit, Philippine peso and Indonesian rupiah. Despite some initial currency stabilization, the problem reared its ugly head and spread like a domino, rapidly knocking down the value of the Taiwan dollar, South Korean won, Singapore dollar and Hong Kong dollar.

Figure 2 Thai 50-Baht Note

In an attempt to prop up their currencies, East Asian governments responded by selling off foreign exchange reserves and raising interest rates, which effectively put the brakes on any hope of a rapid economic recovery. The problem was particularly serious as stable exchange rates were an important component of East Asia’s export-driven economies. With their currencies in freefall, East Asian governments soon fell victim to a host of economic evils, namely:

	Excessive inflation – Because of the rapid devaluation, East Asian currencies lost most of their value and purchasing power. In response, governments resorted to contractionary fiscal policies, making a rapid economic recovery even less likely. This hit Asian consumers particularly hard, as they saw the price of most goods double virtually overnight.
	High interest rates – Believing that higher returns would stem capital flight and attract investors, East Asian governments allowed interest rates to rise. Unfortunately, by increasing the cost of doing business, high interest rates had the unsavory effect of further slowing economic growth.
	Bankruptcy of dollar debtors – East Asian finance companies, banks and commercial enterprises held large amounts of dollar-denominated debt that they were unable to service given the drop in the value of national currencies. In addition, bankruptcies of dollar debtors also contributed to a major credit squeeze and lending contraction

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