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Until 1997, Asia attracted almost half of the total capital inflow to developing countries. The economiesof Southeast Asia in particular maintained high interest rates attractive to foreign investors looking for ahigh rate of return. As a result the region's economies received a large inflow of money and experienceda dramatic run-up in asset prices. At the same time, the regional economies of Thailand, Malaysia,Indonesia, Singapore, and South Korea experienced high growth rates, 8 12% GDP, in the late 1980s and

early 1990s. This achievement was widely acclaimed by financial institutions including the IMF andWorld Bank, and was known as part of the "Asian economic miracle".

1. Introduction

The aim of this paper is twofold. First of all, it reveals that the stock market collapses experienced by anumber of South East Asian economies in 1997 and early 1998 where highly correlated with the

evolution of the currencies of the countries involved. Secondly, using Price/Earnings and Price/Bookratios it is shown that Asian stock markets were not overvalued before the crisis started; thussuggesting that the crisis was not the result of a bursting bubble that some authors such as Krugmanhave argued.

This paper also presents the different theories of stock market co-movements across countries. Thepresence of contagion or inter-dependence among economies of a certain region become importantwith the diminishment of the advantages to investors of international diversification, via increases incross-correlations among stock market returns. The issue of international contagion and inter-dependence has been in the forefront of academic discussions as a result of Mexico s 1994 and Asia s1997-'98 financial crises.

In the second section of this paper the behavior of S.E.-Asian currencies during the crisis is analyzed. Therest of the paper is organized as follows: the third section analyzes the evolution of S.E.-Asian stockmarkets during the crisis; the fourth section inquires whether Asian stock markets were overvaluedbefore the financial crisis erupted; the fifth section presents the different channels of transmissionthrough which the stock market of one country might be influenced by the evolution of other stock

markets; and, finally, the sixth section summarizes and presents the author's conclusions.

2. The Evolution of Asian Currencies During the Financial Crisis

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The Asian financial crisis started with the devaluation of Thailand s Bath, which took place on July 2,1997, a 15 to 20 percent devaluation that occurred two months after this currency started to suffer froma massive speculative attack and a little more than a month after the bankruptcy of Thailand s largestfinance company, Finance One. This first devaluation of the Thai Baht was soon followed by that of thePhilippine Peso, the Malaysian Ringgit, the Indonesian Rupiah and, to a lesser extent, the Singaporean

Dollar. This series of devaluations marked the beginning of the Asian financial crisis. [2] This first sub-period of the currency crisis took place between July and October of 1997. Figures 1A and 1B (below)present the monthly evolution of the currencies of the eight South-East Asian countries studied here forthe period July 1997 (rebased to 100 in all the graphs) to May 1, 1998. [3] Included are the Hong Kong(H.K. Dollar), Indonesia (Rupiah), Malaysia (Ringgit), the Philippines (Peso), Singapore (SG Dollar), SouthKorea (Won), Taiwan (New Dollar) and Thailand (Baht).

A second sub-period of the currency crisis can be identified starting in early November, 1997 after thecollapse of Hong Kong s stock market (with a 40 percent loss in October). This sent shock waves thatwere felt not only in Asia, but also in the stock markets of Latin America (most notably Brazil, Argentinaand Mexico). In addition to these stock markets, were those of the developed countries (e.g. the U.S.experienced its largest point loss ever in October 27, 1997, which amounted to a 7 percent loss). Thesefinancial and asset price crises also set the stage for this second sub-period of large currencydepreciations. This time, not only the currencies of Thailand, the Philippines, Malaysia, Indonesia andSingapore were affected, but those of South Korea and Taiwan also suffered. In fact, the sharpdepreciation of Korea s Won beginning in early November added a new and more troublesomedimension to the crisis given the significance of Korea as the eighth largest economy in the world; themagnitude of the depreciation of its currency which took place in less than two months; and the Korean

Central Bank s success in maintaining the peg ever since the Thai s first devaluation (i.e. the nominalanchor of the largest of the Asian Tigers was suddenly lost). In addition, was the other importantcomponent of this second sub-period: the complete collapse of the Indonesian Rupiah that started atabout the same time.

Finally, starting in January of 1998, the currencies of all of these countries regained part of what theyhad lost since the crises started. It is also important to note that at a great cost Hong Kong was able tomaintain its peg after the crisis first erupted. This required that interest rates be raised to fend-off thesecurrencies from repeated speculative attacks.

3. The Evolution of Asian Stock Markets During the Asian Financial Crisis

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It is necessary to study the evolution of the stock markets and the inflow of money that went to theAsian economies in order to understand the financial crisis of 1997- 1998. Net equity investments in theeconomies of South Korea, Indonesia, Malaysia, Thailand, and the Philippines amounted to US$ 12.2billion in 1994, US$ 15.5 billion in 1995, US$19.1 billion in 1996, and US$ 4.5 billion in 1997 accordingto the Institute of International Finance in 1998. The reversal for 1997 came as a result of the financial

crisis that started in Thailand, which added pressure to the currency markets of the countries consideredin this article. Net equity investments and new private loans financed most of the increasing currentaccount deficits that the SE-Asian economies, as well as most of the developing world, experiencedduring the 1990s. The ability of most of the developing world to import capital through securitiesmarkets was enhanced by the exponential growth in the U.S. mutual fund industry, and the low interestrates available in the U.S. and Japan during the past decade.

Now, through the following figures, let us turn our attention to the behavior of the Asian stock marketindices during the crisis.

Figures 2A and 2B (above) show the monthly evolution of national stock price indices (expressed in USdollars) for these same eight countries and during the same period of time. The stock market indices arethose provided by Morgan Stanley International Capital (MSCI). Figures 3A and 3B (below) show thebehavior of the same Asian stock market indices from January 1997 to May 1998 but expressed in localcurrency. As can be seen, the direction of the stock markets is similar to that of Figures 2A and 2B inwhich the indices where expressed in US$ terms. However, the magnitude of the decline on the localstock market prices is not as pronounced when expressed in local currency.

Figures 3A and 3B (above) show the behavior of the same Asian stock market indices from January 1997to May 1998 but expressed in local currency. As can be seen, the direction of the stock markets is similarto that of Figures 2A and 2B in which the indices where expressed in US$ terms. However, themagnitude of the decline on the local stock market prices is not as pronounced when expressed in local

currency. This finding suggests the existence of a currency effect affecting stock price returns during thecrises, as is explained in the next paragraph.

The finding of a close relationship between exchange rate depreciations and stock returns during a crisisis consistent with Bailey, Chan and Chung (2001). These authors demonstrate, using intraday data, thatthe severe downturn of the Mexican stock market in December 1994 and early 1995 can be associated

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with the Peso devaluation that took place during this same period. In the case of the five Asian countrieswhose currencies experienced the sharpest depreciations during the Asian crisis (Indonesia, Malaysia,Philippines, South Korea, and Thailand) the average correlation between weekly stock market returnsand currency changes (where currency is defined as the number of units of foreign currency per 1 U.S.dollar) between the first week of July 1997 and the first week of May 1998 is 0.63 and is significant at

the 1percent level. My explanation for this strong association is that currency devaluations havetraditionally been accompanied by declining stock markets in the developing world because they haveusually taken place in the middle of a financial crisis and uncertainty about the future course of economic policies and outcomes. For instance, the negative impact of devaluing currencies on S.E.-Asianbanks and companies that had borrowed heavily on international markets most probably surpassed thepotential export gains. But an orderly devaluation such as that of Britain in 1992 did not have negativeeffects on the London stock market since it helped the British economy recover from a three-yearrecession via an export-boom.

4. Were the Stock Markets Overvalued Before the Crisis Started?

The stock markets of Hong Kong, Indonesia, and South Korea fluctuated with no clear trend before thefirst sub-period of the currency crisis began in early July, 1997. The stock markets of Malaysia,Singapore, the Philippines, and Thailand drifted downward during this same sub-period, with the latertwo countries experiencing the sharpest declines. Finally, Taiwan's stock market drifted upwards duringthis same sub-period of time. Therefore, I not see any evidence of a clear pattern of stock marketscollapsing in a contagious fashion before the first round of devaluations took place in July, 1997, as

Krugman (1998) suggested was the case: [4]

And then the bubble burst. The mechanism of crisis, I suggest, involved that same circular process inreverse: falling asset prices made the insolvency of intermediaries visible, forcing them to ceaseoperations, leading to further asset deflation. This circularity, in turn, can explain both the remarkablyseverity of the crisis and the apparent vulnerability of the Asian economies to self-fulfilling crisis whichin turn helps us understand the phenomenon of contagion between economies with few visibleeconomic links.

I have checked the evolution of the same national stock market indices since 1991 (the preceding fiveyears to the crisis) and, on one hand, I found a significant increase in Hong Kong s stock market assetprices (a fourfold increase), while, on the other hand, the remaining seven stock markets stayedremarkably flat, with some minor fluctuations. Furthermore, the performance of the Asian stockmarkets lagged behind the Latin American, the British, and the United States stock markets during the

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same years prior to the crisis. Thus, it seems hard to contend that the collapse of the stock markets inSouth East Asia was the result of a bursting bubble, since the stock prices of the markets of SE-Asia hadhardly any growth six years prior to the currency crises of 1997.

To analyze whether rapidly increasing stock prices represent a bubble; financial economists try toexpress these prices in terms of indicators such as; the earnings of companies which trade stocks in themarket (the P/E or Price/Earnings ratio, and the P/B or Price/Book ratio.) Rising stock prices andearnings may well yield a flat P/E ratio (i.e. there is no bubble since higher stock prices are justified by

fundamentals , at least as it pertains to the P/E ratio.) For instance, authors like Gilibert and Steinherr(1996) contend that the rise in stock prices that took place in Mexico in the early 1990s was the product

of a speculative bubble and that it was not justified by fundamentals. However, analyzing P/E and P/Bratios of Asian stock markets just before the crisis erupted it is difficult to contend that these marketswere overvalued since the ratios were below the world average (See Table 1 above.)

Finally, Table 2 (above) shows that the U.S. stock market had been, on a risk-adjusted basis, the bestmarket performer during the period 1990-96, followed by Latin America, U.K., Asia (excluding HongKong), and Japan. The fact that S.E.-Asian markets plummeted after having lagged behind theperformance of those of the rest of the world, and after having remained relatively flat during the 1990s(i.e. no bubble), is another indication of how severe and dramatic the financial crisis was.

Krugman s assertion is nonetheless consistent with the behavior of national stock prices in South EastAsia after the first round of devaluations. Such evolution had actually preceded the second and moreintense wave of devaluations of November and December of 1997. This is because, as was shown inFigures 2A and 2B (above), between the first and second round of devaluations the stock markets of Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand experiencedsharp declines. Not until the currencies of these countries stabilized in early 1998 were their stockmarkets able to reverse the downward trend in stock prices (except in Indonesia).

In summary, it is difficult to contend that falling stock prices during the Asian crises were the result of abubble that was bursting or that Asian stock markets were overvalued before the crisis first erupted.

5. Stock Market Co-Movements: The Channels of Transmission [5]

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In this section the literature of the determinants of stock market co-movements is briefly examined.

Why do stock market co-movements occur? What are the linkages among stock markets that canexplain a crisis such as the Asian? Calvo and Reinhart (1996) provide a brief summary of the existentexplanations in the context of currency crisis, [6] and in this paper an attempt is made to adapt some of these explanations to the case of stock market co-movements during periods of financial crises, a sub-area in this field that has received relatively little attention. [7] Nonetheless, the inflow of capital to thedeveloping world that took place in the late 1980s and early 1990s was accompanied by an increasingshare of portfolio investments as local stock markets became increasingly open towards foreigninvestors. Such is the case for the Latin America countries where this situation is presented morefrequently than in the South Eastern Asia countries.

Stock market co-movements can be explained as follows:

The first reason is that stock market co-movements may take place when the financial markets of twocountries are highly integrated so that shocks to the larger country are transmitted to the smaller onesvia assets-trading. An example of this type of spillover is the integration of the capital markets of Argentina and Uruguay. As a result of Argentina s 2001-2002 severe crisis and subsequent external debtdefault and currency devaluation, Uruguay has recently been forced to devalue its currency.

The second most important reason are the trade partners and bilateral or multilateral tradearrangements that enhance the possibilities of international shocks. For instance, when the currency of a country experiences a large real depreciation, imports from its trading partners fall, and the tradebalance of the country whose currency is devalued deteriorates, thereby setting the stage for thecurrencies of its neighbors to suffer speculative attacks if the impact is large enough. For example, theBrazilian devaluation of 1999 placed great pressure on Argentina s currency, Brazil s most importanttrading partner.

The third reason (See Chua, 1993.) emphasizes the role of technological factors on economic growth.Technological spillovers between neighboring countries tend to occur because ideas and capital flow arefaster and easier across neighboring countries rather than across distant countries. Thus, the economicgrowth of a country is affected by the economic growth of its neighbors. I have found a highly significantand positive regional spillover effect in a number of the South East Asian countries.

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The first three theories or reasons presented above attempt to explain stock market co-movements as aconsequence of economic linkages among countries. These theories are what Forbes and Rigobon (2000and 2002) might call interdependence explanations. Nevertheless, the last three theories or reasons,

which are of a contagious nature, deal with the effects of investor s behavior on stock markets, theresult of which may cause a stock market crisis or exacerbate an existing one.

The fourth reason, is that spillovers or contagious crises may occur for institutional reasons according tothe theories of Calvo and Reinhart (1996) theories: [8]

In response to a large adverse shock (such as the Mexican devaluation) [9] an open-end emergingmarket mutual fund that is expecting an increasing amount of redemptions will sell off its equityholdings in several emerging markets in an effort to raise cash. However, given the illiquidity thatcharacterizes most emerging markets, the sell-off by a few large investors will drive stock prices lower.Hence, the initial adverse shock to a single country gets transmitted to a wider set of countries.

The fifth reason is that investor s sentiments can generate self-fulfilling crises if foreign investors do notdiscriminate among different macroeconomic fundamentals across countries. There exists a vastliterature on banking and financial crises in the developed world in which the issue of contagion effectsarise frequently. According to Calvo and Reinhart, for example:[10]

In the wake of a bank failure (particularly a large of prominent bank), anxious depositors possessingimperfect information about the soundness of other banks rush to withdraw their deposits from thebanking system at large. The stampede by depositors generates a liquidity crisis that spreads to otherhealthy banks. Thus, herding behavior by depositors alters the "fundamentals" for a broader set of financial institutions and the crisis becomes self-fulfilling...A similar story can be told about investors ininternational currency and equity markets...With regards to emerging markets, however, relatively littleis known about these issues.

The sixth reason is that contagion may occur because of the way market participants interpret possibleco-movements in macroeconomic policies and fundamentals in the economies subject to attack.[Eichengreen, Rose, and Wyplosz (1996)]

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Given the experience of currency crisis being accompanied by stock market collapses in the developingworld (The figures shown above confirmed this in the context of the SE-Asian financial crises), aspeculative currency attack against one currency and the concomitant effects may well triggersimultaneous declines in the stock markets of these same countries.

6. Conclusions

In this paper the currency and stock market collapses experienced by a number of South East Asianeconomies in 1997 and mid 1998 have been examined, and the close relationship between the behaviorof their stock markets during this period and the evolution of the currencies of the countries involvedwas analyzed. Shown was that the severe downturn of the Asian stock markets during the financial crisiscan be associated with the currency devaluations of the five countries whose currencies experienced the

sharpest depreciations during the crises, especially in the case of Indonesia, Malaysia, Philippines, SouthKorea, and Thailand. This was reflected in an average correlation between weekly stock market returnsand currency depreciations of 0.63 during the crisis period.

When the evolution of South East Asian stock markets prior to the crisis was analyzed there was noevidence found of a clear pattern of stock markets collapsing in a contagious fashion before the firstround of devaluations took place in July, 1997 as Krugman (1998) suggested was the case. Krugman sassertion is nonetheless consistent with the behavior of national stock prices in South East Asia after thefirst round of devaluations occurred. Also, the fact that South East Asian stock markets plummeted afterhaving lagged behind the performance of those of the rest of the world, and after having remainedrelatively flat during the 1990s (i.e. no bubble), is another indication of how severe the financial crisiswas.

Stock market co-movements may occur for different reasons. First, they may take place when thefinancial markets of two countries are highly integrated so that shocks to the larger country aretransmitted to the smaller ones via assets-trading. Second, trade partners and bilateral or multilateraltrade agreements enhance the transmission of shocks internationally. Third, spillover effects may be the

result of technological factors or economic growth. Fourth, contagious crisis may occur for institutionalreasons. Fifth, investor s sentiment can generate self-fulfilling contagious crisis if foreign investors donot discriminate among different macroeconomic fundamentals across countries. And sixth, contagionmay occur because of the way market participants interpret possible co-movements in macroeconomicpolicies and fundamentals in the economies subject to attack.

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Even though I did not test any of the theories of contagion in this article, I am inclined to think thatcompetitive devaluations were present during the crisis and that a domino effect was created when

international mutual funds sold Asian stocks and bonds of both crisis and non-crisis countries in an effortto raise cash. These two channels of transmission correspond to the second and fourth theories of contagion outlined in the previous paragraph.

Finally, I conclude that contagion or interdependence across stock market returns diminishes greatly theadvantages of international diversification highlighting the instability of historical correlation coefficientsamong stock market indices when a crisis occurs.

NEW ARTICLETHE 1997-98 ASIAN FINANCIAL CRISIS

Dick K. Nanto, Specialist in Industry and Trade Economics Division

February 6, 1998

Summary

The Asian financial crisis involves four basic problems or issues: (1) a shortage of foreign exchangethat has caused the value of currencies and equities in Thailand, Indonesia, South Korea and otherAsian countries to fall dramatically, (2) inadequately developed financial sectors and mechanisms forallocating capital in the troubled Asian economies, (3) effects of the crisis on both the United Statesand the world, and (4) the role, operations, and replenishment of funds of the International MonetaryFund.

The Asian financial crisis was initiated by two rounds of currency depreciation that have beenoccurring since early summer 1997. The first round was a precipitous drop in the value of the Thai

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baht, Malaysian ringgit, Philippine peso, and Indonesian rupiah. As these currencies stabilized, thesecond round began with downward pressures hitting the Taiwan dollar, South Korean won, Brazilianreal, Singaporean dollar, and Hong Kong dollar. Governments have countered the weakness in theircurrencies by selling foreign exchange reserves and raising interest rates, which, in turn, have slowedeconomic growth and have made interest-bearing securities more attractive than equities. The

currency crises also has revealed severe problems in the banking and financial sectors of the troubledAsian economies.

The International Monetary Fund has arranged support packages for Thailand, Indonesia, and SouthKorea. The packages include an initial infusion of funds with conditions that must be met foradditional loans to be made available.

This financial crisis is of interest to the U.S. government for several reasons. First, attempts to resolvethe problems are led by the IMF with cooperation from the World Bank and Asian Development Bankand pledges of standby credit from the Exchange Stabilization Fund of the United States. Second,financial markets are interlinked. What happens in Asian financial markets also affects U.S. markets.Third, Americans are major investors in the region, both in the form of subsidiaries of U.S. companiesand investments in financial instruments. Fourth, the currency turmoil affects U.S. imports andexports as well as capital flows and the value of the U.S. dollar; the U.S. deficit on trade is now risingas these countries import less and export more. Fifth, the crisis is causing economic turmoil that isexposing weaknesses in many financial institutions in Asia; some have gone bankrupt. The economicproblems of the troubled Asian economies are adversely affecting the United States, Japan, and

others.

The U. S. Congress is likely to consider the Asian financial crisis within three broad legislative contexts.The first is in the financing and scope of the activities of the IMF. This includes legislation to providethe IMF with an increase in its quotas or capital subscriptions, New Arrangements to Borrow, anallocation of Special Drawing Rights, and an amendment to the IMF's Articles of Agreement. Thesecond legislative context is in the impact of the crisis on the U.S. economy and American financialinstitutions. Forecasters foresee a decline in U. S. growth and an increase in the U.S. trade deficitbecause of the crisis. The third context is in efforts to liberalize trade and investment in the world.

Chronology of the Asian Financial Crisis

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* Early May (1997) - Japan hints that it might raise interest rates to defend the yen. The threatnever materializes, but it shifts the perceptions of global investors who begin to sell Southeast Asiancurrencies and sets off a tumble both in currencies and local stock markets.

* July 2 - After using $33 billion in foreign exchange, Thailand announces a managed float of the

baht. The Philippines intervenes to defend its peso.

* July 18 - IMF approves an extension of credit to the Philippines of $1.1 billion.

* July 24 - Asian currencies fall dramatically. Malaysian Prime Minister Mahathir attacks "roguespeculators" and later points to financier George Soros.

* Aug. 13-14 - The Indonesian rupiah comes under severe pressure. Indonesia abolishes its systemof managing its exchange rate through the use of a band.

* Aug. 20 - IMF announces $17.2 billion support package for Thailand with $3.9 billion from the IMF.

* Aug. 28 - Asian stock markets plunge. Manila is down 9.3%, Jakarta 4.5%.

* Sep. 4 - The peso, Malaysian ringgit, and rupiah continue to fall.

* Sep. 20 - Mahathir tells delegates to the IMF/World Bank annual conference in Hong Kong thatcurrency trading is immoral and should be stopped.

* Sep. 21 - George Soros says, "Dr Mahathir is a menace to his own country."

* Oct. 8 - Rupiah hits a low; Indonesia says it will seek IMF assistance.

* Oct. 14 - Thailand announces a package to strengthen its financial sector.

* Oct. 20-23 - The Hong Kong dollar comes under speculative attack; Hong Kong aggressivelydefends its currency. The Hong Kong stock market drops, while Wall Street and other stock marketsalso take severe hits.

* Oct. 28+ - The value of the Korean won drops as investors sell Korean stocks.

* Nov. 5 - The IMF announces a stabilization package of about $40 billion for Indonesia. The UnitedStates pledges a standby credit of $3 billion.

* Nov. 3-24 - Japanese brokerage firm (Sanyo Securities), largest securities firm (YamaichiSecurities), and 10* largest bank (Hokkaido Takushoku) collapse.

* Nov. 21 - South Korea announces that it will seek IMF support.

* Nov 25 - At the APEC Summit, leaders of the 18 Asia Pacific economies endorse a framework tocope with financial crises.

* Dec 5 - Malaysia imposes tough reforms to reduce its balance of payments deficit.

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* Dec 3 - Korea and IMF agree on $57 billion support package.

* Dec 18 - Koreans elect opposition leader Kim, Dae-jung as new President.

* Dec 25 - IMF and others provide $10 billion in loans to South Korea.

* Jan 6 - Indonesia unveils new budget that does not appear to meet IMF austerity conditions. Valueof rupiah drops.

* Jan 8 - IMF and S. Korea agree to a 90-day rollover of short-term debt.

* Jan 12 - Peregrine Investments Holdings of Hong Kong collapses. Japan discloses that its bankscarry about $580 billion in bad or questionable loans.

* Jan 15 - IMF and Indonesia sign an agreement strengthening economic reforms.

* Jan 29 - South Korea and 13 international banks agree to convert $24 billion in short-term debt,

due in March 1998, into government-backed loans.

* Jan 31 - South Korea orders 10 of 14 ailing merchant banks to close.

* Feb 2- The sense of crisis in Asia ebbs. Stock markets continue recovery.

The 1997-98 Asian Financial Crisis

Introduction

The Asian financial crisis involves four basic problems or issues: (1) a shortage of foreign exchange inThailand, Indonesia, South Korea and other Asian countries that has caused the value of currenciesand equities to fall dramatically, (2) inadequately developed financial sectors and mechanisms forallocating capital in the troubled Asian economies, (3) effects of the crisis on both the United Statesand the world, and (4) the role, operations, and replenishment of funds of the International MonetaryFund.

The crisis was initiated by two rounds of currency depreciation that began in early summer 1997. Thefirst round was a precipitous drop in the value of the Thai baht, Malaysian ringgit, Philippine peso, andIndonesian rupiah (see Figure 1). As these currencies stabilized at lower values, the second roundbegan with downward pressures hitting the Taiwan dollar, South Korean won, Brazilian real,Singaporean dollar, and Hong Kong dollar. (See Figure 2.)In countering the downward pressures oncurrencies, governments have sold dollars from their holdings of foreign exchange reserves, bought

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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-bearingsecurities more attractive than equities. Stock prices have fallen. In November 1997, this decline instock values was transmitted to other stock markets in the world, although U. S. and Europeanmarkets have subsequently recovered.

This financial crisis is of interest to the U.S. government for several reasons. First, financial marketsare interlinked. What happens in Asian financial markets also may affect U.S. markets. Second,American banks and companies are significant lenders and/or investors in the region, in terms of bankloans, subsidiaries of U. S. companies, and investments in financial instruments. Third, attempts toresolve the problems have been led by the International Monetary Fund (IMF) with cooperation fromthe World Bank and Asian Development Bank. Some legislative issues dealing with IMF funding andoperations were deferred by the 105* Congress at the close of its recent session. In 1998, Congress isconsidering New Arrangements to Borrow by the IMF, a proposed increase in IMF quotas or capitalsubscriptions, and a proposed amendment to the IMF's Articles of Agreement. Congress also mayintensify its oversight U.S. activities in the IMF.

The fourth reason that the Asian financial crisis is of interest to the United States is that the turmoilaffects 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 isexposing weaknesses in many financial institutions in Asia. Some have gone bankrupt. The economicproblems 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 andthe United States. Sixth, the crisis may impede the progress of trade and investment liberalizationunder the World Trade Organization and the Asia Pacific Economic Cooperation (APEC) forum.

So far, the International Monetary Fund has arranged support packages for Thailand, Indonesia, andSouth Korea, and extended and augmented a credit to the Philippines to support its exchange rateand other economic policies. The three support packages are summarized in Table 1. The totalamounts of the packages are approximate because the IMF lends funds denominated in specialdrawing rights (SDRs), and because pledged amounts may change as circumstances change. Thesupport 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 itsExchange 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 beproper safeguards to limit the risk to American taxpayers.

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The support packages are initiated by a request from the country experiencing financial difficulty. Thisrequest then requires an assessment by IMF officials of the conditions in the requesting nation. If asupport package is approved, the IMF usually begins with an initial loan of hard currency to theborrowing nation. Subsequent amounts are made available (usually quarterly) only if certainperformance targets are met and program reviews are completed. If the financial situation continues

to deteriorate, commitments for funds that have been pledged by the World Bank, AsianDevelopment Bank and certain nations may be tapped. The funds borrowed by the recipient countryusually go into the central bank' s foreign exchange reserves. These reserves are used to supplyforeign exchange to buyers, both domestic and international.

Table 1. IMF Financial Support Packages

(Amounts in U.S.$Billion)

Thailand Indonesia South Korea

Date Approved

(1997)August 20 November 5 December 4

Total Pledged $17.2 $40 $57

IMF $3.9 $10.1 $21.0

U. S. None $ 3.0 $5.0

World Bank $1.5 $ 4.5 $10.0

Asian Development $1.2 $ 3.5 $ 4.0

Bank Japan $4.0 $ 5.0 $10.0

Others $6.6 $26.0 $ 7.0

Change in Exchange Rate -38% -81% -50%

(7/1197- 1/22/98)

Change in Stock Market -26% -40% -30%

(7/1/97-1/19/98)

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Source: International Monetary Fund, Dialogue Database, Wall Street Journal, Financial Times.

In addition to support packages by the IMF, other international organizations have been addressingthe Asian financial crisis. On November 3-5, 1997, the Group of Fifteen developing nations met inMalaysia and developed a plan to avert renewed currency turbulence. In preparation for the AsiaPacific Economic Cooperation (APEC) summit meeting, senior finance officials of APEC met in Manilaon November 18-19 and developed a framework for dealing with financial crises in the region. ThisManila Framework was endorsed by the eighteen leaders of the economies of APEC at the forum'sannual summit in Vancouver, BC, on November 25, 1997. The Manila Framework recognized that therole of the IMF would remain central and included enhanced regional surveillance, intensifiedeconomic 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. 1

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 theregion. It would be provided only if a country accepted an IMF support package and if ASEANmembers consider IMF funds to be inadequate.2 On December 15, 1997, ASEAN heads of stateendorsed 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 theircommitment to maintain an open trade and investment environment in ASEAN.3

The IMF and Stabilization Packages

The International Monetary Fund has been the key player in coordinating support packages for thetroubled Asian economies. The IMF says that it has learned from the Mexican Peso crisis in 1995 andhad instituted emergency procedures that enabled it to respond to each the crises in each Asiancountry 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.4 They are:

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*

* 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, and

* helping 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). At the September1997 annual meeting of the IMF in Hong Kong, the Board of Governors approved moving ahead todevelop an amendment of the IMF Articles of Agreement to make the liberalization of internationalcapital flows one of the purposes of the Fund. For the United States, this change would presumablyrequire Congressional approval.

The Asian financial crisis also has raised several questions pertaining to IMF operations. The first iswhether such crises have increased in scale and whether IMF resources are sufficient to cope withthem. (IMF funding is discussed in the final section of this report on issues for Congress.) The second iswhether the Fund's willingness to lend in a crisis contributes to moral hazard (a tendency for apotential recipient country to behave recklessly knowing that the IMF will likely bail them out in anemergency). The third is whether the contagion of financial crises can be stopped effectively. Thefourth is conditionality-whether the changes in economic policy and performance targets that the IMFrequires of the recipient countries are appropriate and effective. The fifth is transparency-whetherthe IMF releases sufficient information to the public, including investors, on its program design andprovisions 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 membercountries to prevent financial crises from occurring.5

With respect to the scale of financial crises, it is clear that recent liberalization of capital marketsand advances in telecommunications have increased the scale of financial crises. The size of thesupport packages for South Korea and Indonesia have been unprecedented. The question is whetherthe IMF has sufficient resources to handle more financial crises, particularly if they occursimultaneously.

With respect to moral hazard, the opinion of the IMF is that governments in trouble usually are tooslow 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 butthat, because IMF support is available, the private sector may be too willing to lend. Private sectorfinancial institutions know that a country in trouble will go to the Fund rather than default on

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international loans. 6 Others, moreover, assert that the IMF is perpetuating the moral hazard that liesat the heart of the problem for troubled economies like South Korea-the absence of bankruptcy. Somecorporations in certain countries have not been allowed to fail because of political or other reasons. Inthe words of one commentator, "Capitalism without bankruptcy is like Christianity without hell. Thereis no systematic means of controlling sinful excesses."7

With respect to contagion, the track record of the IMF in stopping the spread of the financial crisiswithin Asia has not been reassuring. Outside of Asia, however, the crisis has yet to spread, althoughcurrencies in Brazil and other countries also have depreciated somewhat.

With respect to IMF conditionality, this continues to be hotly debated with each IMF supportpackage. 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 ineconomic growth in the troubled Asian economies will only worsen their economic problems.8

With respect to transparency, critics of the IMF claim that the institution does not releasesufficient data to the public and investors who have financial interests in the success or failure of theIMF support packages and who need more information to devise effective strategies to cope with thecrises.9 The IMF, however, does release more information now that it did previously. Also, the IMFmay leave it to the borrowing country to release detailed information.

With respect to prevention, the IMF has little leverage over member countries who are notborrowers. Countries also have to assess the possibility of a future crisis in light of immediate politicalexigencies-particularly elections. For example, prior to the financial crisis in Thailand, even though theIMF might have warned the country that it was headed for trouble, it was difficult for the Thai leadersto muster the political support to restructure the 58 financial institutions that eventually becameinsolvent. The IMF Support Package for Thailand

The support package for Thailand announced by the IMF on August 20, 1997, (eventually worth$17.2 billion) included:

* an IMF stand-by credit of up to SDR 2.9 billion 10 (about US$3 .9 billion) over the ensuing 34months to support the government's economic program [Of the total, SDR 1.2 billion (about US$1.6billion) was available immediately and a further SDR 600 million (about US$810 million) was to bemade available after November 30, 1997, provided that end-September performance targets had

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been met and the first review of the program has been completed. Subsequent disbursements, on aquarterly basis, would be made available subject to the attainment of performance targets andprogram reviews.],

* loans of up to $1.5 billion from the World Bank, and

* loans of up to $1.2 billion from the Asian Development Bank. The package also included thefollowing pledges

* credit of $4 billion from Japan' s Export-Import Bank, and

* credits of $1 billion each from Australia, Hong Kong, Malaysia, Singapore, and China, and

* credits of $0.5 billion from Indonesia, Brunei, and Korea (Korea's was later retracted). Accordingto 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. ll

The IMF also placed certain conditions on Thailand. These reportedly included that the countrycommit 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 abudget surplus equal to 1% of its GDP in FY1998. The IMF Support Package for Indonesia

For Indonesia, the IMF announced a support package on November 5, 1997, that totaled $40billion. The package included first-line financing amounting to about $23 billion to include: 12

* IMF standby credit of SDR 7.338 billion (about $10.14 billion) with SDR 2.2 billion (about $3.04billion) available immediately and further disbursements after March 15, 1998, provided that certaintargets 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 ormonetary authorities have committed to provide a second line of supplemental financing "in theevent that unanticipated adverse external circumstances create the need for additional resources tosupplement Indonesia's reserves and the resources made available by the IMF." These include:

* Japan-$5.0 billion,

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* Singapore-$5.0 billion,

* United States-$3.0 billion

* $1.0 billion each from Australia, Malaysia, China, and Hong Kong. . Previously, Singapore also hadpromised an additional $5 billion to Indonesia in foreign exchange, if needed, to purchase rupiah. 13Funds from the United States are in the form of a back-up line of credit from the ExchangeStabilization Fund 14 at appropriate interest rates. The U.S. Treasury characterized this as contingentfinancial support to be used as a temporary "second line of defense" in the event that unanticipatedexternal pressures were to give rise to a need to supplement Indonesia' s own reserves and theresources made available by the IMF. Since the fund is under the control of the Secretary of theTreasury, use of its funds does not require congressional approval. Treasury, however, has indicatedthat if funds are disbursed, they would carry proper safeguards to limit the risk to Americantaxpayers.15

As part of the support package, Indonesia was required to restructure certain banks, dismantle aquasi-governmental monopoly on all commodities (except rice), cut fuel subsidies, increase electricityrates, increase the transparency of public policy and budget-making processes, and speed upprivatization and reform of state enterprises. It was not required, however, to change its national carpolicy or aircraft development program. The IMF Support Package for South Korea

The IMF support package for South Korea was announced in Seoul on December 3, 1997 and wasformally approved by the IMF on the following day. It eventually consisted of $57 billion as follows: 16* IMF - three-year standby credit of SDR 15.5 billion (about $21 billion),

* World Bank-$10 billion,

* Asian Development Bank-$4 billion.

* United States-$5 billion from its Exchange Stabilization Fund,l7

* Japan-$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 contingentupon South Korea' s remaining in compliance with the IMF arrangement.

In return for accepting the IMF emergency loans, Korea agreed to several conditions and reforms inorder to strengthen its economy. On the macroeconomic side, the conditions included:

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* reducing its current-account deficit to no more than 1% of GDP for 1998 and 1999 (about $5billion),

* 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, and

* recognizing that economic growth (in terms of GDP) for 1998 would likely fall from 6% to around3%. In terms of financial restructuring, the IMF required a comprehensive restructuring andstrengthening 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 andsupervisory discipline, and increased competition. The measures included:

* requiring that all banks that fail to meet the Basle Committee capital standards be restructuredand recapitalized to include mergers and acquisitions by foreign institutions and losses byshareholders,

* replacing the government guarantee of bank deposits by the end of the year 2000 with a regulardeposit insurance system,

* upgrading accounting and disclosure standards to include audits of financial statements of largefinancial institutions and semi-annual disclosure of nonperforming loans, capital adequacy, andownership structures and affiliations,

* requesting passage of legislation to make the Bank of Korea independent with price stability as itsoverriding mandate and setting up an agency to consolidate financial sector supervision, and

* allowing foreign banking and securities companies to establish affiliated companies in Korea bythe middle of 1998. In terms of structural policies, the IMF package required the Korean governmentto take several measures. These included:

* setting a timetable in line with World Trade Organization commitments to eliminate trade-relatedsubsidies, restrictive import licensing, and Korea's import diversification program (aimed at Japan),

* increasing to 50% (from 26%) the ceiling for foreign investment in listed Korean firms and furtherincreasing it to 55% by the end of 1998,

* by the end of February 1998, taking steps to liberalize other capital account transactions, includingrestrictions on access by foreigners' to domestic money market instruments and corporate bondmarkets, and

* easing labor dismissal restrictions under mergers and acquisitions and corporate restructuring. 18Frank-Sanders Amendment

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The support packages of the IMF appear to be subject to the requirements of the Frank-Sandersamendment (U.S.C. 22 262p-4p). Among its provisions, the Frank- Sanders amendment requires theU. S. Treasury to direct the U. S. Executive Directors of the International Financial Institutions (such asthe IMF and World Bank) to use the voice and vote of the United States to urge the respectiveinstitution to adopt policies to encourage borrowing countries to guarantee internationally recognized

worker rights and to include such rights as an integral part of the institution's policy dialogue witheach borrowing country. In testimony before the House Banking Committee in November 1997, theU.S. Treasury indicated that it had "spoken out within the World Bank and IMF, in advancing thepurposes of the Frank-Sanders Amendment, to promote measures that would help improve theconditions of workers in Indonesia, Thailand, and across the developing world.''l9 Others believe,however, that the IMF's Indonesian support package was not in accord with the Frank-SandersAmendment.20 Bailout?

IMF assistance to the above three countries has been criticized for "bailing out" commercial banksand 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 witheconomy wide, structural imbalances and not to protect commercial banks and private investors fromfinancial losses.21 A more stable exchange rate may contribute to a recovery on stock markets orbetter business conditions, but there is no IMF "bailout" of specific investors.

As for bailouts of manufacturing or other nonfinancial corporations, the IMF claims that there areno provisions in the IMF-supported programs for public-sector guarantees, subsidies, or support for

them. Shareholders and creditors bear losses, although individual governments may devise separatepolicies for dealing with such cases. Any company in need of foreign exchange, however, usually isbetter off when foreign exchange markets are stabilized.

As for financial corporations, the IMF recognizes that governments often guarantee accounts of certain categories of depositors (deposit insurance). Liquidity support also can be provided toundercapitalized, but solvent, financial institutions. According to the IMF, however, such supportnormally requires that institutions be capable of actually being recapitalized and restructured torestore them to health.22

Imprudent lenders or investors in the recipient countries have not escaped real losses. In Korea,for example, the operations of 14 of 30 merchant banks have been suspended. The remainingmerchant banks also are to be closed unless they submit rehabilitation plans. Two commercial banksin Korea also will be required to be recapitalized and restructured. In Indonesia, 16 insolvent banks

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have been closed, and weak but viable banks have been required to submit rehabilitation plans. InThailand, 56 of 91 finance companies are to be liquidated. As for investors in equity markets, they alsohave incurred losses. In January 1998, U. S. Federal Reserve Chairman Alan Greenspan indicated thatbecause of the financial crisis, foreign investors in Asian equities (excluding those in Japan) had lost anestimated $700 billion-including $30 billion by Americans.23

Another aspect of moral hazard is whether the IMF support packages rescue creditors in New YorkTokyo, and Europe from their poor lending decisions. There is little doubt that banks which have loansoutstanding in Asia have much to gain by a return to stability in Asian financial markets. To the extentthat the IMF support packages have contributed to that stability and to the extent that the infusion of dollars by the IMF has enabled borrowers or others in need of foreign exchange to purchase more of it, U.S. banks and other creditors have gained. Banks, however, still face large potential and reallosses from their operations in Asia.

For example, in 1997, the Asian turmoil reduced Citicorp's pretax earnings by about $250million.24 The Bank of America reported that as of December 31, 1997, it had assets of $24.0 billion inAsia (up from $20.4 billion in December 1996), but net income from Asia had dropped from $224million in 1996 to -$218 million in 1997.25 During the fourth quarter of 1997, J.P. Morgan designatedas nonperforming approximately $587 million of its total $5.4 billion in loans, swaps, and debtinvestment securities in Indonesia, Thailand, and South Korea. The bank reported charge-offs of $24million during the quarter-mostly related to Asia, and considered about 60% of its total allowance forcredit losses of $1 .081 billion to be related to exposures in the three troubled Asian countries.26

Effects on the U.S. Economy The Asian Financial Crisis affects the U.S. economy both in amacroeconomic and microeconomic sense. On the macroeconomic level, it likely will affect the U. S.growth rate, interest rates, balance of trade, and related variables. On a microeconomic level, it canaffect specific industries, each in a different way that depends on their relationship to the troubledAsian economies.

The mechanism by which the U.S. macroeconomy is affected is through trade and capital flows.The depreciation in the values of the South Korean won, Indonesian rupiah, Singaporean dollar, Thaibaht, Philippine peso, Japanese yen, Taiwan dollar, and other Asian currencies (except for the HongKong dollar and Chinese RMB) combined with a slowing of growth and financial difficulties of banksand manufacturing corporations in these countries is expected to increase the U. S. trade deficit. Inthe Asian countries, the immediate effect of the change in the value of their currencies and outflowsof capital is to reduce their trade deficits, and, in some cases, to generate a trade surplus. This is

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already occurring in South Korea. Much of this increased trade surplus for Asia is likely to come at theexpense of the United States.

The second macroeconomic mechanism by which the Asian financial crisis affects the U.S.economy is through capital flows. As the contagion began and Asian banks and corporations began toface severe financial difficulties, a concern arose in the United States that Asian holders of Americanfinancial assets, particularly U.S. Treasury securities, might be forced to pull them out of the U. S.economy in order to generate much needed cash. It seems, however, that a "flight to quality"occurred instead. Both American and foreign investors withdrew liquid capital (by selling securitiesand not rolling over loans) from the troubled Asian countries and moved them into the United States.This has eased the upward pressure on U. S. interest rates and is likely to have a positive effect on U.S. economic growth. Economic Growth

Forecasters project that U.S. economic growth will slow by 1.3 percentage points (or 34%) from3.8% in 1997 to about 2.5% in 1998.2' (See Figure 3.) This U.S. slowdown is being caused primarily bytwo factors: the Asian financial crisis and tightness in U.S. labor markets. Most forecasters estimatethat the Asian financial crisis will reduce U.S. growth in 1998 by 0.5 to 1.0 percentage point.

A comparison of forecasts for U.S. economic growth made in January 1998 with those made beforethe onset of the Asian financial crisis in July 1997, however, reveals one unexpected result. Theforecasts for economic growth made in January 1998, in most cases, were higher than those publishedin July 1997 before the crisis. The main reason for this seems to be that in mid-1997 forecasters werewary of the Federal Reserve Board's concern over the run-up in the U.S. stock market, tightening labormarkets, and the likelihood that the Federal Reserve would raise U.S. interest rates. These concernswere eased by the correction in the U.S. stock market in October 1997 and by the financial turmoil inAsia. The rising U.S. trade deficit with Asia, therefore, is expected to be offset by the easing of upwardpressures on U.S. interest rates. Trade Deficit

Forecasters expect the 1998 U.S. trade deficit to increase significantly because of the drop in the

value of currencies in Asia, net capital inflows, and the slowdown in growth in those economies. (SeeFigure 4) The capital inflows into the United States and outflows from the troubled Asian economiesimply that the respective current accounts 28 must move in the opposite direction. For the UnitedStates, a rise in the surplus in the capital account implies an offsetting rise in the deficit in the U.S.current account - most of which is trade in goods and services.

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As shown in Figure 4, the consensus of 50 forecasters compiled by Blue Chip Economic Indicators isfor real net exports of goods and services to decline by about $43 billion from an estimated -$146.3billion in 1997 to -$189.2 billion in 1998. Prior to the Asian financial crisis, the consensus forecastcompiled by Blue Chip Economic Indicators was for the balance of real U. S. exports and imports of goods and services to improve and for the deficit to become smaller in 1998. From July 1997 to

January 1998, the consensus forecast for this balance worsened by $63 billion.

Standard & Poor's Data Resources, Inc. expects the U.S. merchandise trade deficit (customs value)to increase by $33.5 billion from $182.7 billion in 1997 to $216.2 in 1998 and further to $248.1 billionin 1999. It expects the U.S. deficit on current account likewise to rise by $27.3 billion from $163.8billion in 1997 to $191.1 billion in 1998 and further to $211.8 billion in 1999. 29

As shown in Figure 5, the United States already runs a deficit in its merchandise trade with theAsian countries that have experienced currency problems - except for South Korea. In most cases, thedeficits are estimated to remain high or increase in 1997. Microeconomic Effects

On a microeconomic level, the Asian Financial Crisis affects those industries most closely linked tothe economies in question. The following provides a rough outline of the major U.S. sectors affected.

* U.S. creditors and investors in Asia-U.S. banks, pension funds, and investors stand to lose on theirpre-crisis exposures, but "bottom fishers" may gain as Asian equity markets recover and currencies

strengthen.

* U.S. exporters to Asia-U. S. makers of major export items, such as heavy equipment, aircraft,manufacturing machinery, and agricultural commodities are seeing demand for their products decline.U. S. producers of commodities used in the manufacture of products in Asia also are experiencing softprices (e.g. chemicals, cotton, copper, and rubber).

* U.S. businesses that compete with imports from Asia - U. S. manufacturers of automobiles,apparel, consumer electronics, steel, and other products that compete with imports from Asia arelikely to see increased competition and downward pressures on prices. Exporters from Korea,however, report that they are experiencing difficulty obtaining foreign exchange to finance importsneeded in their production processes. This, in turn, constrains their exports. U. S. labor engaged inmanufacturing competing products tend to be hurt by Asian exchange depreciation.

* U.S. businesses related to interest rates-mortgage bankers, refinancing companies, builders, andother businesses that benefit from lower rates of interest are seeing greater activity.

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* U.S. businesses the sell imports from Asia-distributors and retailers of products from the troubledAsian economies are likely to have increased activity. These include discount retailers and Koreanautomobile dealers.

* U.S. multinational corporations seeking market access in Asia-U.S. companies, particularly in the

financial sector, that have encountered barriers to entry or restrictions on their activities in Indonesia,Thailand, and South Korea are likely to benefit from the market opening required by the IMF supportpackages. They also may be able to buy existing firms that need restructuring and recapitalization atrelatively low prices.

* U.S. multinational corporations with manufacturing subsidiaries in Asia -Most U.S. companieswith direct investments in the region will probably weather the storm, although some investments(such as the new General Motors plant in Thailand) have been thrown into question. Since about 60%of the output from U.S. manufacturing subsidiaries in Asia is sold in the region, local sales are likely tostagnate until economic growth resumes. Some excess capacity may emerge. For a manufacturingsubsidiary in a country with a depreciated local currency, its cost of imported components will tend torise, but the price of the finished export to the U.S. and other hard currency markets will tend to fall.

* U.S. industries that use components from Asia-U.S. manufacturers that use parts and other inputsfrom Asian countries whose currencies have depreciated are likely to experience lower costs of production. An overall indicator of the effect of the Asian financial crisis on U.S. businesses is theoutlook for corporate profits. The increased competition from imports combined with rising wagecosts in the United States is expected to reduce the growth in U.S. corporate profits in 1998 to about4.7% or roughly half the increase in 1997.30

Causes of the Financial Crisis

The causes of financial problems in these countries are many and differ somewhat from economyto economy. In general, the Asian Tiger economies had been growing at rates of 5 to 10% per year forthe past decade. They were opening their economies to foreign direct investments, foreign goods andservices, capital flows, and were relying heavily on dollar markets, particularly the United States, toabsorb their exports. In order to attract foreign investments and facilitate capital flows, their currencyexchange rates were kept in fairly close alignment with the U.S. dollar or a basket of currencies

dominated by the dollar.

The financial services sector in most of these newly industrialized economies had been developingrapidly and without sufficient regulation, oversight, and government controls. As capital marketswere liberalized, banks in these countries could borrow abroad at relatively low rates of interest andre-lend the funds domestically. Over the past decade, foreign borrowing by these countries had

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shifted from a preponderance of government to private sector borrowing. Whereas in the 1970s, thegovernments might have borrowed for infrastructure development from the World Bank or aconsortium of international banks, in the 1990s, a local bank might borrow directly from a large NewYork money center bank. The financial crisis in Asia began in currency markets, but this exchange rateinstability was caused primarily by problems in the banking sectors of the countries in question.

The causes and structural factors contributing to the financial crises include:

* private-sector debt problems and poor loan quality,

* rising external liabilities for borrowing countries,

* the close alignment between the local currency and the U. S. dollar,

* weakening economic performance and balance-of-payments difficulties,

* currency speculation,

* technological changes in financial markets, and

* a lack of confidence in the ability of the governments in question to resolve their problemssuccessfully.

Bank Borrowing and Lending

The financial difficulties in Asia stemmed primarily from the questionable borrowing and lendingpractices of banks and finance companies in the troubled Asian economies. Companies in Asia tend torely more on bank borrowing to raise capital than on issuing bonds or stock. Governments also havepreferred developing financial systems with banks as key players. This is the Japanese model forchanneling savings and other funds into production rather than consumption. With bank lending, thegovernment 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 lowrates 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). Aweakness 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.

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For example, Figure 6 outlines the lending system in South Korea. Korean banks and large businessesborrow in international markets at sovereign (national) rates and re-lend the funds to domesticbusinesses. The government bureaucrats often can direct the lending to favored and well-connectedcompanies. The bureaucrats also write laws regulating businesses, receive approval from theparliament, 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 bureaucratsto direct scarce capital toward favored companies. 31

International borrowing involves two other types of risk. The first is in the maturity distribution of accounts. The other is whether the debt is private or sovereign. As for maturity distribution, manybanks and businesses in the troubled Asian economies appear to have borrowed short-term forlonger-term projects. Many economists blame such loans for the Asian crisis.32 Some of this debt is tofinance 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 generatingenough 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 theseloans (obtaining new loans as existing ones mature) may not be particularly difficult. Competitionamong banks is intense. In the Asian case, as U. S. banks began to restrict lending in certain Asiancountries 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.33

Figure 7 shows the total amount borrowed by selected Asian countries and the distribution of thematurities on those accounts. For the six Asian countries shown, all have relied heavily on debt with amaturity of one year or less. At the end of 1996, the proportion of loans with maturity of one year orless was 62% for Indonesia, 68% for South Korea, 50% for the Philippines, 65% for Thailand, and 84%for Taiwan.

A structural change in the 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 financialinstitutions (such as the World Bank) or receiving development assistance funds through foreign aidprograms to borrowing by private corporations.

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Figure 8 shows the distribution of borrowing from banks according to the type of borrower. Untilcapital markets were liberalized in the newly industrializing countries of Asia, most of the outsidefunds flowing into these economies was borrowed by the governments (public sector). Now majorbanks and the non-bank private sector account for most of the borrowing.

A problem with private sector borrowing in developing market economies is that while individualborrowers may have viable projects, when all borrowing is aggregated and demands for foreignexchange and repayment are tallied, the country can face difficulties. It is a type of fallacy of composition. Even if each individual loan is financially viable, the total of all loans may not be sobecause the nation may be short of the foreign exchange necessary to meet the repayment schedules.

Although Japan is not considered to be one of the Asian economies experiencing a currency crisis, it

has been experiencing many of the same problems that are confronting its Asian neighbors. Japan'sbanking sector, for example, carries an estimated $600 billion in questionable and nonperformingloans despite aggressive writeoffs in recent years.34 When world attention began to be focused onJapan's problem of nonperforming bank loans, its government first announced in 1994 that the totalamount of such loans was about $136 billion. A year later, it admitted that the total was more like$400 billion or about 9% of gross national product. Private analysts, however, put the figure atroughly double that amount.35 Since 1992, the top 20 Japanese banks have written off approximately35 trillion yen (about $290 billion) in bad loans.36 Still, the combination of the weak Japanese stockmarket, weak real estate values, and sluggish economy continues to threaten Japan' s banks as well assecurities companies.

Although the currency crisis has not affected mainland China's renminbi to a large extent, China stillhas the potential of experiencing a major financial crisis. The problem began in 1981 when thegovernment changed the banking system from one in which banks financed investments and providedfunds to enterprises as part of the government's central plan to one based more on bankingprinciples. Banks were to provide funds only as loans rather than as investments and were to chargeinterest and require repayments. Suddenly, the flow of funds from the banks to state-ownedenterprises became liabilities that had to be repaid.

China's four state-owned specialty banks do 75% of the nation's deposit and loan business. Data onthe condition of these banks is sketchy, but in late 1994, the four banks reported over 570 billion yuan(about $68 billion) in bad loans or about 20% of all the loans they had issued. Overdue loans were11.3%, idle loans 7.7% and uncollectible loans 1.3%. These accounted for 90% of the officiallyrecognized bad loans in the banking system.37 These figures, however, are likely to be understated

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because the state-owned banks have been lending to state-owned enterprises, and only about 30% of those enterprises are profitable, 20% have been losing money for years and are beyond salvaging, andthe remaining 50% are somewhere in between.38

The state-owned banks, therefore, have accumulated a huge portfolio of bad debts that have littleprospect of being repaid. As was pointed out at a conference in Beijing in January 1997, China'snational economy is being threatened by a latent monetary credit crisis. Furthermore, even thoughloans now are supposed to be allocated according to sound banking principles, in practice a largeamount of monetary assets is still being allocated ineffciently through administrative and plannedeconomic channels. State-owned banks have been required to provide loans to support enterpriseswhich are running at low profit rates or at a loss. These are "loans for preservation of stability andunity" and "loans for clearing up defaults." The resultant depletion of assets of state-owned banks hasbecome an important factor threatening their own survival.39

Bank Exposure

How exposed are the banks of the major industrial countries to borrowers in these Asian economies?Table 2 shows the international claims (loans) of all reporting banks in the United States, UnitedKingdom, Germany, Japan, and the world with respect to selected Asian countries involved in thefinancial crisis. Bank lending data pose a particular problem because of offshore banking centers, suchas Aruba, the Bahamas, Hong Kong, and Singapore. Often the banks in these centers simply provide aconduit for funds that ultimately are used outside the center. Table 2, therefore, shows two sets of totals: one for countries and one for offshore banking centers. (The two sets of data are notcompletely compatible.)

At the end of 1996, the U.S. banks reported $29.1 billion in loans outstanding to Indonesia, SouthKorea, Malaysia, the Philippines, Taiwan, and Thailand. There was an additional $14.4 billion loanedto 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 itsloans to these eight Asian economies and Germany 33.6%. Table 2. International Claims (Loans) byBanks in Selected Developed Nations on Borrowers in Troubled Asian Economies December 31, 1996($Millions)

Claims on by- U.S. U K. Germany Japan World

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Indonesia 5,279 3,834 5,508 22,035 55,523

South Korea 9,355 5,643 9,977 24,324 99,953

Malaysia 2,337 1,417 3,857 8,210 22,231

Philippines 3,902 1,173 1,820 1,558 13,289

Taiwan 3,182 2,773 2,628 2,683 22,363

Thailand 5,049 3,128 6,914 37,525 70,181

Total Above Asia 29,104 17,968 30,704 96,335 283,540

Asian Offshore Banking Centers

Hong Kong 8,665 26,216 26,811 87,462 207,164

Singapore 5,727 22,523 40,767 58,809 189,310

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Total Asian Offshore 4,392 48,739 67,578 146,271 396,474

Total Asia + Asian 57,888 66,707 98,282 242,606 680,014

Offshore Centers

Total World 130,053 68,325 173,101 169,699 993,134

Total Offshore 35,617 63,024 119,170 219,690 663,897

Banking Centers

Total World + 165,670 131,349 292,271 389,389 1,657,031

Offshore Centers

Asia as % of World 34.9 50.8 33.6 62.3 41.0

(Including Offshore Banking Centers)

Note: Data are for lending which is outside of the home market (does not include domestic lending).Data from offshore banking centers are not completely compatible with BIS reporting country data.Source: Bank for International Settlements. The Maturity, Sectoral and Nationality Distribution of International Bank Lending. Second Half 1996. Basle, Switzerland, July 1997. P. 19-20.

Japan's bank exposure was particularly high. It reported 62.3% of its international lending to theseAsian countries. In the offshore centers, Japan reported $87.5 billion in Hong Kong and $58.8 billion in

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Singapore. For Thailand, Japan reported $37.5 billion in claims, and more than $20 billion each inIndonesia and South Korea.

The U. S. Federal Financial Institutions Examination Council provides more recent data that thoseavailable through the Bank for International Settlements (BIS) used above. BIS data also have beenadjusted somewhat to eliminate double counting and to be consistent across reporting nations. TheCouncil data indicate that U.S. bank claims in these Asian economies declined after December 1996from $45.2 billion for these eight Asian economies to $41.9 billion as of June 30, 1997. This amountedto 0.2% of total U.S. banking assets of $2,552.5 billion and 1.5% of total banking capital of $272.8billion.40 It appears that U.S. banks had become aware of the increasingly risky loan environment inAsia and in 1997 had been reducing exposure accordingly.

U.S. banks do not seem to be excessively exposed to the Asian economies suffering from currencyweaknesses. This is a vastly different picture than was presented at the onset of the Latin Americandebt crisis in August 1982. In December 1982, U.S. banks were owed $24.4 billion by Mexico alone.This amounted to 34.6% of their total capital and about 2.0% of their total assets. 41

In addition to dollar-denominated claims, the U. S . Federal Financial Institutions Council also reportedthat U. S. banks have claims for loans in local currencies that do not appear in BIS statistics. As of June30, 1997, these loans amounted to $1,403 million in Hong Kong, $74 million in Indonesia, $1,150million in Malaysia, $1,567 million in Philippines, $1,288 million in Singapore, $1,363 million inTaiwan, and $2,023 million in Thailand.

Pegged Exchange Rates

The 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 narrowbands.

The advantage of this system to the countries involved was that it kept the countries' exchange ratesrelatively constant with respect to the dollar and allowed their traders to import from and export todollar areas, particularly the United States, with little exchange rate risk. It also provided a stable

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financial environment that encouraged foreign sources of capital for loans or investments. The Thaimonetary authorities, for example, had pursued a "stable baht" policy that had kept the official ratefor their currency at about 25 baht per dollar since 1987. This linking of official exchange rates to thedollar, 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, eventhough 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, asthe dollar appreciated and the official values of these currencies deviated from their underlyingmarket values. While the dollar was pulling up the value of these currencies, some of the countries inquestion encountered increasing difficulty in balancing their international accounts. Their exportsgrew more costly to non-dollar buyers, and their imports from non-dollar areas cheaper. The weakyen, in particular, was reducing the competitiveness of their products relative to those from Japan.The consequent rising deficits in their trade and current accounts placed downward pressure on theirexchange rates which required more and more government intervention to maintain.

When downward pressures on a currency occur in foreign exchange markets, if the exchange rate isallowed to adjust freely, an initial depreciation tends to lessen pressures for more depreciation. Therewards for speculating in the market (by betting on a future depreciation) diminish. With anexchange rate tied to the dollar, however, government attempts to maintain the rate often raise theexpectations of traders that the currency is headed for a fall. This places even more downwardpressure on the currency as traders rush to sell it in anticipation that they will be able to buy it later ata 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 thecurrency to depreciate. When that process begins, the fall in the currency may be quite dramatic andmay overshoot the equilibrium rate.

Currency depreciation, in turn, places an additional burden on local borrowers whose debts aredenominated in dollars. They now are faced with debt service costs that have risen in proportion tothe currency depreciation. These debtors respond to the weakening currency by attempting to hedgeexternal liabilities which intensifies exchange rate and interest rate pressures.42 In the South Koreancase, for example, the drop in the value of the won from 886 to 1,701 won per dollar between July 2

and December 31, 1997, nearly doubled the repayment bill when calculated in won for Korea's foreigndebts. The depreciated local currency, however, makes exports from the country cheaper and morecompetitive in foreign markets.

Nominal exchange rates also may change in response to differing rates of inflation among countries. Ahigh inflation rate will cause a nation's currency to depreciate, but the real exchange rate (adjusted

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for inflation) may remain the same. In some of the Asian countries with currency problems, inflationrates have been higher than those in the United States. Still a depreciation of 20 or 30% far exceedsinflation rates in 1997 of about 3% in Malaysia and Taiwan, 5% in South Korea, and 7% in Indonesia,the Philippines, and Thailand.

As the Asian financial crisis has progressed, the affected governments (except for Hong Kong) haveeased the rigidity of their exchange rate systems. Exchange rates now are allowed to move in widerbands, in a crawling band, or are floating. This flexibility reduces the potential for large and suddenchanges in these exchange values, as the rates respond continuously and in smaller increments tomarket forces.

Government exchange rate policy suffers from a common policy dilemma. If a country targets its

monetary and fiscal policy toward maintaining a specific exchange rate, it must sacrifice performancein its domestic economy. A government defending its exchange rate, for example, usually has to raiseinterest rates in order to attract capital into its economy. This tends to dampen its growth rate.Government policymakers do not have policy tools that enable them to target both an exchange rateand economic growth rate.

With respect to pegged exchange rates, however, there is an alternative school of thought thatcurrency values should be pegged to gold or some other standard of value and kept stable.43 Thosewho view exchange rates in these terms may see the cause of the currency crises in the Asiancountries as excessive expansion of domestic money supplies by central banks combined withburdensome government regulations, protection of domestic industries, and other governmentinterference in the marketplace.44 Once governments stopped maintaining their exchange rates,investors lost confidence, and the crises began. Economic Growth

Most of the countries in Asia that now are encountering currency problems had logged remarkablyhigh economic growth rates over the past decade. These high rates of growth brought higherstandards of living but also brought problems. To one degree or another, most of these countries have

been facing difficulties with their balance of payments, over-expansion of production capacity, risingreal estate values, overvalued equities, and excessive bank lending. As of first quarter 1997 before thecrisis began, the growth rates for these Asian countries had remained quite high, and the outlook wasgenerally favorable. Any dramatic slowdown in growth had not yet appeared in their short-termoutlook.

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As shown in Figure 9, economic growth rates over the past decade for four countries involved in thefirst round of currency problems. The forecast for 1997 is as of the first quarter, before the currencycrisis began. As can be seen, growth was slowing but still remained at remarkably high rates and wasexpected to continue in 1997. Thailand's economic growth rate had fallen from 13% in 1988 to 6.5% in1996. In 1997, however, it was expected to recover from its downward slide.

The effect of a slowdown in growth on a nation's exchange rate is not immediately obvious. It affectsboth trade and capital accounts in opposite ways. On one hand, lower growth usually causes anation's trade balance to improve, since imports decline relative to exports (unless demand in exportmarkets is falling faster). This could strengthen a nation's currency. In the Asian case, however,growth was continuing at a level high enough that trade and current accounts tended to remain indeficit. Even in Thailand, the slowdown had not improved its balance of trade.

On the capital account side, a slowing growth rate generally causes problems for a nation's debtorswho have borrowed to finance production facilities or have invested in real estate or equities and arefaced with repayment schedules. Lower growth means lower demand, possible lower profits, and aleveling off or fall in real estate and stock values. As the slowdown intensifies, interest rates usuallyfall. This can cause international lenders to look elsewhere for investment for financing opportunitiesand may cause a weakening of a nation's currency. Recessions also cause loans to turn sour and mayfurther drive away foreign lenders. As the Asian financial crisis has developed, forecasters havelowered their outlook for growth in these countries. The securities firm, J.P. Morgan, for example,lowered its forecast for economic growth for ASEAN (Indonesia, Malaysia, Singapore, Thailand,

Philippines, Brunei, and Vietnam) for 1998 from 5.9% in June 1997 (before the crisis began) to 2.2% inNovember 1997.45 Forecasters expect economic growth in South Korea to drop from 5.9% in 1997 toaround -1.5% in 1998.46 Current Account Imbalances

The high growth rates among the Asian countries had begun to create problems for them in balancingtheir current and trade accounts. The current account is a nation's balance of trade in imports andexports plus net income from foreign investments, and unilateral transfers. It consists of thepayments for goods and services, interest and dividends, and remittances by foreign workers to theirhome countries. Figure 10 shows current account balances for four of the Asian nations that have hadto depreciate their currencies. (Comparable data for Malaysia were not available from the IMF.) In thecase of Thailand, its deficit in its current account had been widening from 1992. In 1996, the deficithad grown t