What caused the Asian currency and financial crisis?

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Abstract

The paper explores the view that the Asian currency and financial crises in 1997 and 1998 reflected structural and policy distortions in the countries of the region, even if market overreaction and herding caused the plunge of exchange rates, asset prices and economic activity to be more severe than warranted by the initial weak economic conditions. The first part of the paper provides an overview of economic fundamentals in Asia on the eve of the crisis, with emphasis on current account imbalances, quantity and quality of financial ‘overlending’, banking problems, and composition, maturity and size of capital inflows. The second part of the paper presents a reconstruction of the Asian crisis from the antecedents in 1995–1996 to the recent developments in early 1999 in parallel with a survey of the debate on the strategies to recover from the crisis, the role of international intervention, and the costs and benefits of capital controls.

Introduction

What were the causes of the Asian economic, currency and financial crises of 1997–1998? Two main hypotheses and interpretations have emerged in the aftermath of the crisis. According to one view, sudden shifts in market expectations and confidence were the key sources of the initial financial turmoil, its propagation over time and regional contagion. While the macroeconomic performance of some countries had worsened in the mid 1990s, the extent and depth of the 1997–1998 crisis should not be attributed to a deterioration in fundamentals, but rather to panic on the part of domestic and international investors, somewhat reinforced by the faulty policy response of the International Monetary Fund (IMF) and the international financial community.1

According to the other view  advanced in this paper  the crisis reflected structural and policy distortions in the countries of the region. Fundamental imbalances triggered the currency and financial crisis in 1997, even if, once the crisis started, market overreaction and herding caused the plunge of exchange rates, asset prices and economic activity to be more severe than warranted by the initial weak economic conditions. A synthetic overview of our interpretation is provided in Section 2, while 3 Current account imbalances and macroeconomic fundamentals, 4 The role of the financial system, 5 Imbalances in foreign debt accumulation and management present a systematic assessment of the sources of economic tension at the root of the Asian crisis. This is based on the analysis of the available empirical evidence for the following countries: South Korea, Indonesia, Malaysia, Philippines, Thailand, Singapore, Hong Kong, China and Taiwan. Macroeconomic imbalances in these countries are assessed within a broad overview of structural factors: current account deficits and foreign indebtedness, growth and inflation rates, savings and investment ratios, budget deficits, real exchange rates, foreign reserves, corporate sector investment, measures of debt and profitability, indexes of excessive bank lending, indicators of credit growth and financial fragility, monetary stances, debt-service ratios, dynamics and composition of capital inflows and outflows, and political instability.

The rest of the paper is structured as follows. Section 6 presents a construction of the Asian meltdown, from the period leading to the crisis to its eruption in 1997, and discusses policy responses, contagion effects, and the role of Japan. In Section 7 we provide an overview of the debate on policy strategies to recover from the crisis, with particular emphasis on the role played by the IMF. Section 8 singles out the key points in the current debate about the reform of the international financial system and the desirability of free capital mobility. Section 9 focuses on the most recent evolution of the Asian meltdown into a global turmoil in the summer of 1998 and the recovery of early 1999.

Section snippets

At the root of the Asian crisis

Central to a full understanding of the roots of the Asian crisis is the multifaceted evidence on the structure of incentives under which the corporate and financial sectors operated in the region, in the context of regulatory inadequacies and close links between public and private institutions.

The evidence

We start our study of the Asian crisis by assessing the evidence on current account imbalances in the region over the 1990s. The potential role of current account deficits as a source of disruptive tensions in the financial markets has been repeatedly emphasized in the literature.

The role of the financial system

The previous section has highlighted a number of country-specific and global factors that determined the current account imbalances observed in Asia on the eve of the crisis, and undermined their sustainability. In this Section, we argue that the key to a comprehensive interpretation of the events leading to the Asian meltdown of 1997 is the analysis of the structure of incentives under which not only the corporate but also the banking and financial sectors operated in the region.

The links

The foreign debt burden and the role of short-term external debt

An otherwise solvent country may suffer a short-run liquidity problem when the available stock of reserves is low relative to the overall burden of external debt service (interest payments plus the renewal of loans coming to maturity). Liquidity problems emerge when panicking external creditors  perhaps in response to rapid devaluation  become unwilling to roll over existing short-term credits. So, if a large fraction of a country’s external liabilities are short-term, a crisis may take the form

A reconstruction of the Asian crisis

In the first sections of the paper we have carried out a detailed analysis of macroeconomic indicators at the onset of the Asian collapse in 1997. In this Section we present a reconstruction of the unfolding of the crisis, in the context of our assessment of the evidence on structural distortions in the Asian region.

The discussion of how the crisis erupted in 1997 is preceded by a country-by-country overview of the build-up of macroeconomic pressures in the region. This overview is focused on

Strategies to recover from the crisis: an overview of the recent debate

Before delving into the analysis of the most recent developments in the region, we devote two sections of our study to a brief assessment of the current debate on the policy strategies to recover from the crisis.79 This section focuses on the

The Asian crisis and the debate on capital controls

Vis-à-vis the persistent and pervasive nature of the current crisis, the terms of the current debate have progressively encompassed such items as the reform of multilateral institutions, the future of economic and financial cooperation and, most importantly, the desirability of deregulation and liberalization of international capital markets. The crucial question in this debate is whether exchange controls and limited capital mobility should become elements of an overall strategy of

From regional crisis to global turmoil in the summer of 1998

In the summer of 1998, what had been until then a severe regional economic crisis in East Asia turned into a devastating global turmoil enveloping a large group of emerging markets and spreading even to the US (and other OECD) capital markets. During 1998, forecasts of the economic slowdown in the crisis countries were steadily revised downward. The economic recession in East Asia spread from the crisis countries (Korea, Indonesia, Thailand and Malaysia) to Hong Kong, Singapore, the Philippines

Acknowledgements

We thank two anonymous referees, Ignazio Visco, and the seminar participants at the NBER IFM Program Meeting, March 1998, the CEPR-World Bank Conference on ‘Financial Crises: Contagion and Market Volatility’, May 1998, the University of Washington, and the Bank of Italy for helpful comments on the earlier drafts of this paper. We also thank Michele Cavallo, Scott Nicholson and Andrew Tiffin for excellent research assistance. Giancarlo Corsetti acknowledges financial support from MURST. The

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