Ethos Issue 3, Oct 2007

The Asian Financial Crisis in Hindsight
Donald Low

The Asian Financial Crisis might well be the first major crisis of globalisation. Donald Low examines its causes and implications ten years on.

The 1997/98 Asian Financial Crisis hit the fastest growing economies in the world, and prompted the largest financial bailouts by international financial institutions (IFIs) in history. It brought to an end decades of strong economic growth among Asian economies that were previously lauded for their sound economic policies of export orientation, balanced budgets, and high savings and investment rates.

Beginning in Thailand and spreading to Indonesia, South Korea, Malaysia and the Philippines, the contagion effects of the crisis were felt as far as Russia and Brazil. It dealt a sharp blow to fragile and over-extended banking systems, resulted in a severe tightening of credit in the Asian economies, forced a sharp depreciation of all their currencies, and led to a major economic contraction in Asia.

THE ORIGINS OF THE CRISIS
The essence of the crisis was a huge, sudden reversal of capital flows. Asian economies that were previously attracting large amounts of foreign capital suddenly experienced withdrawals of short-term lines of capital, an exodus of portfolio investments, and capital flight by domestic investors. Net capital inflows of US$93 billion into the five most affected Asian economies (South Korea, Indonesia, Thailand, Malaysia and the Philippines: the Asian-5) in 1996 were suddenly replaced by a net capital outflow of US$12 billion in the second half of 1997. Most of the turnaround arose from a US$73 billion reversal in net bank lending flows, with the sharpest outflows recorded in Thailand and Korea of some US$18 billion each.¹

During and immediately after the crisis, much of the debate among economists centred on whether the Asian crisis was caused by weak economic and financial fundamentals, or by financial panic unrelated to economic conditions. Certainly, most of the macroeconomic indicators of financial stability gave little reason to expect a major crisis in any of the affected countries at the time. Budgets were generally in balance or showing surpluses. By emerging country standards, inflation rates were relatively low (below 10%), and stable or declining. Savings and investment rates were high and generally rising prior to the crisis.² Indeed, the crisis was largely unanticipated because the economies were pursuing the export-led model of growth that had sustained the Asian economic miracle of the preceding two decades. Confidence was buttressed by the glowing reviews these economies received in various World Bank and Asian Development Bank reports, and in International Monetary Fund (IMF) assessments.

Ironically, the optimism of the IFIs had helped to create a general bullishness among governments, investors and borrowers in the long-term economic prospects of the East Asian economies, obscuring serious microeconomic problems that beset their corporate and financial sectors. These included a legacy of bad lending and investment practices fostered by a climate of relationship-based lending; disincentives to monitor risk due to the implicit guarantee of government bailouts; and inadequate supervision and regulation of domestic financial institutions. These vulnerabilities, combined with financial sector liberalisation from the 1990s onwards and de facto fixed exchange rate regimes, led to increasing exposures to credit risks and ever more fragile financial systems. Bank claims on the private sector grew exponentially in the years leading up to the crisis.³

The abundance of inexpensive capital from abroad, combined with lending based on non-economic considerations, led to a misallocation of capital into speculative and uncompetitive ventures, particularly in real estate and equity markets. Even before the crisis struck, bank and non-bank balance sheets were already deteriorating as the quality of investments in the Asian-5 countries declined and the proportion of non- performing loans increased substantially.

FINANCIAL PANIC AND THE SPREAD OF THE CRISIS
In 1996 and early 1997, the asset bubble created by cheap foreign capital and excessive lending began to burst in some countries, notably Thailand and Korea, where stock market and real estate prices fell sharply. The emergence of wide losses and defaults in the corporate sector also highlighted the low profitability of past investment projects. This led to a massive capital withdrawal, although the immediate triggers differed from country to country.

Once the bubble bursts, panic in financial markets played a key role in explaining why the crisis was more severe than weak fundamentals alone might suggest. Domestic investors began to look more critically at weaknesses that had been previously ignored; new information in an environment with poor disclosure further amplified concerns about the quality of investments, the size of foreign borrowings, and the stability of the financial system. As the crisis expanded, domestic residents became less willing to hold assets in domestic financial institutions and foreign creditors became less willing to roll over their loans, causing a liquidity squeeze that led to the bankruptcy of financial institutions as well as private firms that had borrowed from them. Thus the initial loss of confidence turned into a self-reinforcing creditors’ panic.

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