ASIAN FINANCIAL CRISIS 1997-98

ASIAN FINANCIAL CRISIS1997-98Kubsha Ameen10247OverviewUnlike the Debt crisis in Latin America, the debt crisis in East Asia stemmed from inappropriateborrowingby the private sector. Due to high rates of economic growth and a booming economy, private firms and corporations looked to finance speculative investment projects. However, firms overstretched themselves and a combination of factors caused a depreciation in the exchange rate as they struggled to meet the paymentsOn July 2, 1997, the Government of Thailand abandoned its efforts to maintain a fixed- exchange rate the Baht had been pegged to a basket of currencies dominated by the U.S. dollar and allowed the Baht to float. This Baht quickly depreciated, falling 18% on the first day alone. The collapse of the Thai Baht was followed by speculative attacks on other countries currencies (including the Indonesian Rupiah, the Malaysia Ringitt, the Philippine Peso, and the Korean Won) and to a further round of forced devaluations. The collapse of fixed exchange rates was accompanied by a series of more general financial sector crises in several of these countries. Although the precise details vary, the immediate cause appears to be a mismatch between assets and liabilities in the corporate and banking sectors (in both currency and term length) and a sharp decline in asset values. These immediate problems were exacerbated by general financial sector weakness due to inadequate supervision and rampant insider lending.

The visible problems with macroeconomic stability were large, and potentially unsustainable, current account deficitsrapid appreciation of currencies which were pegged to the dollar a slowdown in growth due to sectoral weakness (especially in semi-conductors) and stagnation in Japan. The large current account deficits made the countries vulnerable to shifts in investor confidence or to a slowdown in economic growth while the rapid appreciation of the U.S. dollar led the currencies to become overvalued. When Thailand had floated its currency, this increased pressure on other countries to do the same to maintain comp The current account deficits were not the result of dis-saving by the government (i.e., fiscal deficits), but were caused by large inflows of private investment. effectiveness in export markets.CausesForeign debt-to-GDP ratios rose from 100% to 167% in the four large ASIAN economies in 1993-96.Countries like Thailand, Indonesia, South Korea had largecurrent accountdeficits. Financed by hot money flows (on capital account). Hot money flows were accumulated because of higher interest rates in the East.Financial deregulation encouraged more loans and helped to create asset bubbles.

Booming economy and booming property markets encouraged expansive borrowing by firms.In the late 1990s, the US increasedinterest ratesto reduce inflationary pressures. Higher interest rates in the US, made the East less attractive as a place to move hot money flows. As hot money flows into the east dried up, currencies started to fall and governments struggled to keep exchange rates at their fixedlevelagainst the US Dollar.

Thailand was the first to have to float the Thai Bhat, this caused a rapid devaluation, which triggered a loss of confidence throughout the Asian economies. Soon, other countries were forced to devalue as investors wanted to get out of Asian currencies.The devaluation caused debt to be even more difficult to repay and countries started to default.At this stage the IMF intervened to try and stabilise the crisis. However, their intervention has proved very controversial, with many arguing that their intervention made things worse.The IMF insisted on fiscal restraint lower spending, higher taxes and privatization. This contractionary fiscal policy caused the economic downturn to exacerbate and the economy plunged into recession. Bankruptcies increased and there was a flight of capital.Inadequate bank regulation and supervision.Over-valued exchange rates that were often pegged to the U.S. dollar which was, at that time, appreciating quite rapidly.A currency mismatch between assets and liabilities that left banks and enterprises vulnerable to exchange rate devaluations.

Basic Issuesa shortage of foreign exchange in Thailand, Indonesia, South Korea and other Asian countries that has caused the value of currencies and equities to fall dramatically.inadequately developed financial sectors and mechanisms for allocating capital in the troubled Asian economies.effects of the crisis on both the United States and the world.the role, operations, and replenishment of funds of the IMF.10The crisis was initiated by two rounds of currency depreciation that began in early summer 1997. The first round was a precipitous drop in the value of the Thai baht, Malaysian ringgit, Philippine peso, and Indonesian rupiah .As these currencies stabilized at lower values, the second round began with downward pressures hitting the Taiwan dollar, South Korean won, Brazilian real, Singaporean dollar, and Hong Kong dollar. In countering the downward pressures on currencies, governments have sold dollars from their holdings of foreign exchange reserves, bought their own currencies, and have raised interest rates to foil speculators and to attract foreign capital. The higher interest rates, in turn, have slowed economic growth and have made interest-bearing securities more attractive than equities. Stock prices have fallen. In November 1997, this decline in stock values was transmitted to other stock markets in the world, although U. S. and European markets have subsequently recovered.

Financial crisis as a matter of interest for the U.S. governmentFirstly financial markets are interlinked, What happens in Asian financial markets also may affect U.S. markets.Secondly American banks and companies are significant lenders and/or investors in the region, in terms of bank loans, subsidiaries of U. S. companies, and investments in financial instruments.Third, attempts to resolve the problems have been led by the International Monetary Fund (IMF) with cooperation from the World Bank and Asian Development Bank.Fourth, the turmoil affects U.S. imports and exports as well as capital flows and the value of the U.S. dollar. The U.S. deficit on trade is now rising as these countries import less and export more.Fifth, the crisis is exposing weaknesses in many financial institutions in Asia. Some have gone bankrupt. The economic problems of the so-called Asian Tigers not only are adversely affecting the economies of Japan and others in the region, but, to some extent, an economic slowdown could spread to Latin America and the United States.Sixth, the crisis may impede the progress of trade and investment liberalization under the World Trade Organization and the Asia Pacific Economic Cooperation (APEC) forum.IMF Support Packages So far, the International Monetary Fund has arranged support packages for Thailand, Indonesia, and South Korea, and extended and augmented a credit to the Philippines to support its exchange rate and other economic policies. The support package for Thailand was $17.2 billion, for Indonesia about $40 billion, and for South Korea $57 billion. The United States pledged $3 billion for Indonesia and $5 billion for South Korea from its Exchange Stabilization Fund (ESF) as a standby credit that may be tapped in an emergency. The U. S. Treasury lends money from the ESF at appropriate interest rates and with what it considers to be proper safeguards to limit the risk to American taxpayers.In addition to support packages by the IMF, other international organizations have been addressing the Asian financial crisis. On November 3-5, 1997, the Group of Fifteen developing nations met in Malaysia developed a plan to avert renewed currency turbulence. In preparation for the Asia Pacific Economic Cooperation (APEC) summit meeting, senior finance officials of APEC met in Manila on November 18-19 and developed a framework for dealing with financial crises in the region. This Manila Framework was endorsed by the eighteen leaders of the economies of APEC at the forum's annual summit in Vancouver, BC, on November 25, 1997. The Manila Framework recognized that the role of the IMF would remain central and included enhanced regional surveillance, intensified economic and technical cooperation to improve domestic financial systems regulatory capacities, adoption of new IMF mechanisms on appropriate terms in support of strong adjustment programs, and a cooperative financing arrangement to supplement, when necessary IMF resources. On December 1, 1997, the finance ministers of the Association of Southeast Asian Nations (ASEAN-Indonesia, the Philippines, Singapore, Thailand, Malaysia, Myanmar, Brunei, Laos, and Vietnam) agreed to make additional funding available for any future bailouts for troubled economies in the region. It would be provided only if a country accepted an IMF support package and if ASEAN members consider IMF funds to be inadequate. On December 15, 1997, ASEAN heads of state endorsed the Manila Framework, efforts of the IMF, decided to develop a regional surveillance mechanism that would emphasize preventive efforts to avoid financial crises, and reaffirmed their commitment to maintain an open trade and investment environment in ASEAN.The IMF and Stabilization PackagesThe International Monetary Fund has been the key player in coordinating support packages for the troubled Asian economies. The IMF says that it has learned from the Mexican Peso crisis in 1995 and had instituted emergency procedures that enabled it to respond to each the crises in each Asian country in record time. The major objectives of the IMF are to promote stability, balanced expansion of trade, and growth, but because of the Asian financial crisis, it has deepened its activities in four directions:strengthening IMF surveillance over member countries' policies,helping to strengthen the operation of financial markets (technical assistance),providing policy advice and financial assistance quickly when crises emerge, andhelping to ensure that no member country is marginalized (being left behind in the expansion of world trade and being unable to attract significant amounts of private investment).Questions raised on IMF operationsFirst whether such crises have increased in scale and whether IMF resources are sufficient to cope with them. The second is whether the Fund's willingness to lend in a crisis contributes to moral hazard (a tendency for a potential recipient country to behave recklessly knowing that the IMF will likely bail them out in an emergency). The third is whether the contagion of financial crises can be stopped effectively. The fourth is conditionality-whether the changes in economic policy and performance targets that the IMF requires of the recipient countries are appropriate and effective. The fifth is transparency-whether the IMF releases sufficient information to the public, including investors, on its program design and provisions imposed as a condition for borrowing allow for accurate assessment and accountability. The sixth is prevention-whether the IMF has sufficient leverage over non-borrowing member countries to prevent financial crises from occurring.Scale of financial crisisWith respect to the scale of financial crises, it is clear that recent liberalization of capital markets and advances in telecommunications have increased the scale of financial crises. The size of the support packages for South Korea and Indonesia have been unprecedented. The question is whether the IMF has sufficient resources to handle more financial crises, particularly if they occur simultaneously.Moral hazardWith respect to moral hazard, the opinion of the IMF is that governments in trouble usually are too slow in approaching the Fund for help because of the conditions the IMF places on such support. According to the IMF, the real moral hazard is not with governments engaging in unsound lending but that, because IMF support is available, the private sector may be too willing to lend. Private sector financial institutions know that a country in trouble will go to the Fund rather than default on international loans. Others, moreover, assert that the IMF is perpetuating the moral hazard that lies at the heart of the problem for troubled economies like South Korea-the absence of bankruptcy. Some corporations in certain countries have not been allowed to fail because of political or other reasons is no systematic means of controlling sinful excesses.Contagion and ConditionalityWith respect to contagion, the track record of the IMF in stopping the spread of the financial crisis within Asia has not been reassuring. Outside of Asia, however, the crisis has yet to spread, although currencies in Brazil and other countries also have depreciated somewhat.With respect to IMF conditionality, this continues to be hotly debated with each IMF support package. Some claim the monetary and fiscal policies required by the IMF are too stringent and slow economic growth too much. The World Bank, in particular, reportedly fears that the slowdown in economic growth in the troubled Asian economies will only worsen their economic problems.TransparencyWith respect to transparency, critics of the IMF claim that the institution does not release sufficient data to the public and investors who have financial interests in the success or failure of the IMF support packages and who need more information to devise effective strategies to cope with the crises.9 The IMF, however, does release more information now that it did previously. Also, the IMF may leave it to the borrowing country to release detailed information.PreventionWith respect to prevention, the IMF has little leverage over member countries who are not borrowers. Countries also have to assess the possibility of a future crisis in light of immediate political exigencies-particularly elections. For example, prior to the financial crisis in Thailand, even though the IMF might have warned the country that it was headed for trouble, it was difficult for the Thai leaders to muster the political support to restructure the 58 financial institutions that eventually became insolvent.Support package for Thailand by IMF (August 20, 1997)an IMF stand-by credit of up to SDR 2.9 billion 10 (about US$3 .9 billion) over the ensuing 34 months to support the government's economic program [Of the total, SDR 1.2 billion (about US$1.6 billion) was available immediately and a further SDR 600 million (about US$810 million) was to be made available after November 30, 1997, provided that end-September performance targets had been met and the first review of the program has been completed. Subsequent disbursements, on a quarterly basis, would be made available subject to the attainment of performance targets and program reviews.],loans of up to $1.5 billion from the World Bank, andloans of up to $1.2 billion from the Asian Development Bank.The package also included the following pledgescredit of $4 billion from Japan' s Export-Import Bank, andcredits of $1 billion each from Australia, Hong Kong, Malaysia, Singapore, and China, andcredits of $0.5 billion from Indonesia, Brunei, and Korea (Korea's was later retracted). According to the IMF, the proceeds from the credits extended by the IMF and the bilateral lenders are to be used solely to help finance the balance of payments gap in Thailand and to rebuild the official reserves of the Bank of Thailand.

Conditions imposed by IMFThese reportedly included that the country commit itself to maintaining foreign exchange reserves at $23 billion in 1997 and $25 billion in 1998, slash its current account deficit to about 5% of GDP in 1997 and to 3% of GDP in 1998, and show a budget surplus equal to 1% of its GDP in FY1998.Support Package for Indonesia by imf (November 5, 1997)IMF standby credit of SDR 7.338 billion (about $10.14 billion) with SDR 2.2 billion (about $3.04 billion) available immediately and further disbursements after March 15, 1998, provided that certain targets have been met;technical assistance and loans from the World Bank of $4.5 billion,technical assistance and loans from the Asian Development Bank of $3.5 billion, and$5.0 billion from Indonesia's contingency reserves.In addition, a number of other countries or monetary authorities have committed to provide a second line of supplemental financing "in the event that unanticipated adverse external circumstances create the need for additional resources to supplement Indonesia's reserves and the resources made available by the IMF.Japan-$5.0 billion,Singapore-$5.0 billion,United States-$3.0 billion$1.0 billion each from Australia, Malaysia, China, and Hong Kong

Conditions imposed by imfAs part of the support package, Indonesia was required to restructure certain banks, dismantle a quasi-governmental monopoly on all commodities (except rice), cut fuel subsidies, increase electricity rates, increase the transparency of public policy and budget-making processes, and speed up privatization and reform of state enterprises. It was not required, however, to change its national car policy or aircraft development program.Support Package for South Korea by imf (December 3, 1997)World Bank-$10 billion,Asian Development Bank-$4 billion.United States-$5 billion from its Exchange Stabilization Fund,l7Japan-$10 billion,$ 1 billion each from the United Kingdom, Germany, France, Australia, Canada, and Italy,additional support from Belgium, the Netherlands, ana Switzerland. The funds are contingent upon South Korea' s remaining in compliance with the IMF arrangement.Conditions imposed by imfreducing its current-account deficit to no more than 1% of GDP for 1998 and 1999 (about $5 billion),capping its yearly inflation rate at 5% in 1998 and 1999,building international reserves to more than two months of imports by the end of 1998, andrecognizing that economic growth (in terms of GDP) for 1998 would likely fall from 6% to around 3%. In terms of financial restructuring, the IMF required a comprehensive restructuring and strengthening of Korea' s financial system in order to make it more sound, transparent, and efficient. The strategy comprised three broad elements: a clear and firm exit policy, strong market and supervisory discipline, and increased competition.

criticism about IMF assistance IMF assistance to the above three countries has been criticized for "bailing out" commercial banks and private investors at the expense of other less-favored groups and U. S. taxpayers. The IMF insists, however, that its assistance has been provided to support programs that are designed to deal with economy wide, structural imbalances and not to protect commercial banks and private investors from financial losses. A more stable exchange rate may contribute to a recovery on stock markets or better business conditions, but there is no IMF "bailout" of specific investors.Bank Borrowing and LendingThe financial difficulties in Asia stemmed primarily from the questionable borrowing and lending practices of banks and finance companies in the troubled Asian economies. Companies in Asia tend to rely more on bank borrowing to raise capital than on issuing bonds or stock. Governments also have preferred developing financial systems with banks as key players. This is the Japanese model for channeling savings and other funds into production rather than consumption. With bank lending, the government is able to exert much more control over who has access to loans when funds are scarce. As part of their industrial policy, governments have directed funds toward favored industries at low rates of interest while consumers have had to pay higher rates (or could not obtain loans) for purchasing products that the government has considered to be undesirable (such as foreign cars). A weakness of this system is that the business culture in Asia relies heavily on personal relationships. The businesses which are well-connected (both with banks and with the government bureaucracy) tend to have the best access to financing. This leads to excess lending to the companies that are well-connected and who may have bought influence with government officials.Korean banks and large businesses borrow in international markets at sovereign (national) rates and re-lend the funds to domestic businesses. The government bureaucrats often can direct the lending to favored and well-connected companies. The bureaucrats also write laws regulating businesses, receive approval from the parliament, write the implementing regulations, and then enforce those regulations. They have had great authority in the Korean economic system. The politicians receive legal (and sometimes illegal) contributions from businesses. They approve legislation and use their influence with the bureaucrats to direct scarce capital toward favored companies.Two risks of international borrowingThe first is in the maturity distribution of accounts. The other is whether the debt is private or sovereign. As for maturity distribution, many banks and businesses in the troubled Asian economies appear to have borrowed short-term for longer-term projects. Many economists blame such loans for the Asian crisis. Some of this debt is to finance trade and is self-extinguishing as the trade transactions are completed. Mostly, however, these short-term loans have fallen due before projects are operational or before they are generating enough profits to enable repayments to be made, particularly if they go into real estate development.As long as an economy is growing and not facing particular financial difficulties, rolling over these loans (obtaining new loans as existing ones mature) may not be particularly difficult. Competition among banks is intense. In the Asian case, as U. S. banks began to restrict lending in certain Asian countries in 1996 and 1997, European banks took up much of the slack. When a financial crisis hits, however, loans suddenly become more difficult to procure, and lenders may decline to refinance debts. Private-sector financing virtually evaporates for a time.Proportion of loans For the six Asian countries shown, all have relied heavily on debt with a maturity of one year or less. At the end of 1996, the proportion of loans with maturity of one year or less was 62% for Indonesia68% for South Korea50% for the Philippines65% for Thailand84% for Taiwan.Structural changeThe nature of the borrowing by these Asian countries is that the type of borrowing has shifted away from the government and banks borrowing from international financial institutions (such as the World Bank) or receiving development assistance funds through foreign aid programs to borrowing by private corporations.Bank exposureHow exposed are the banks of the major industrial countries to borrowers in these Asian economies? Bank lending data pose a particular problem because of offshore banking centers, such as Aruba, the Bahamas, Hong Kong, and Singapore. Often the banks in these centers simply provide a conduit for funds that ultimately are used outside the center. At the end of 1996, the U.S. banks reported $29.1 billion in loans outstanding to Indonesia, South Korea, Malaysia, the Philippines, Taiwan, and Thailand. There was an additional $14.4 billion loaned to Hong Kong and Singapore for a total of $57.9 billion. This amounted to 34.9% of all U.S. international lending (including offshore banking centers). The greatest U.S. exposure was in Hong Kong and South Korea. As for other major lending countries the United Kingdom reported 50.8% of its loans to these eight Asian economies and Germany 33.6%.Pegged Exchange RatesThe structural factor that initially enabled the crisis to occur was that the exchange rates of most of these currencies had been aligned with the dollar or a basket of currencies dominated by the dollar. These pegged exchange values had not been allowed to adjust sufficiently in response to changing economic conditions. Governments allowed their exchange rates to fluctuate only within narrow bands.The advantage of this system to the countries involved was that it kept the countries' exchange rates relatively constant with respect to the dollar and allowed their traders to import from and export to dollar areas, particularly the United States, with little exchange rate risk. It also provided a stable financial environment that encouraged foreign sources of capital for loans or investments. The Thai monetary authorities, for example, had pursued a "stable baht" policy that had kept the official rate for their currency at about 25 baht per dollar since 1987. This linking of official exchange rates to the dollar, however, had one major drawback. As the value of the dollar changed, so did the value of these currencies relative to others, such as the Japanese yen and German mark, that were not tied to the U.S. dollar.As the dollar depreciated after 1985, the arrangement worked reasonably well, even though macroeconomic conditions in these countries differed widely from those in the United States (particularly, rates of inflation and growth). Problems began to arise in 1996 and 1997, however, as the dollar appreciated and the official values of these currencies deviated from their underlying market values. While the dollar was pulling up the value of these currencies, some of the countries in question encountered increasing difficulty in balancing their international accounts. Their exports grew more costly to non-dollar buyers, and their imports from non-dollar areas cheaper.When downward pressures on a currency occur in foreign exchange markets, if the exchange rate is allowed to adjust freely, an initial depreciation tends to lessen pressures for more depreciation. The rewards for speculating in the market (by betting on a future depreciation) diminish. With an exchange rate tied to the dollar, however, government attempts to maintain the rate often raise the expectations of traders that the currency is headed for a fall. This places even more downward pressure on the currency as traders rush to sell it in anticipation that they will be able to buy it later at a lower price. If the governments involved do not have sufficient foreign exchange reserves to stave off the speculators and others in the market, they eventually have to concede failure and allow the currency to depreciate.Currency depreciation, in turn, places an additional burden on local borrowers whose debts are denominated in dollars. They now are faced with debt service costs that have risen in proportion to the currency depreciation. These debtors respond to the weakening currency by attempting to hedge external liabilities which intensifies exchange rate and interest rate pressures.Nominal exchange rates also may change in response to differing rates of inflation among countries. A high inflation rate will cause a nation's currency to depreciate, but the real exchange rate (adjusted for inflation) may remain the same. In some of the Asian countries with currency problems, inflation rates have been higher than those in the United States. Still a depreciation of 20 or 30% far exceeds inflation rates in 1997 of about 3% in Malaysia and Taiwan, 5% in South Korea, and 7% in Indonesia, the Philippines, and Thailand.Lessons learned from asian financial crisisLawsons Rule that it is okay to run a current account deficit without a budget deficit has proven to be a fallacy; Foreign exchange reserves are important; Information and transparency are key; The composition of capital inflows does matter;Exchange rate regimes are extremely difficult to maintain; Financial markets are not perfectly efficient; Moral hazard is the central market failure;IMF programs should consist of both macroeconomic and structural reforms; Inevitably, countries will have to raise interest rates and lower exchange rates; and Keynesianism is alive and well in Asia.