The Asian Financial Crisis

The "tiger economies" of Southeast Asian States were hit by the ever time worst Financial Crisis
between June 1997 and January 1998. Over the previous decade these Southeast Asian states of
Thailand, Malaysia, Singapore, Indonesia, Hong Kong, and South Korea, had achieved some of
the most impressive economic growth rates in the world, expanding by 6% to 9% p.a., as
measured by GDP. However, this Asian phenomenon appeared to come to an abrupt end in late
1997 when in one after another all the countries’ local stock markets and currency markets
collapsed. Till January 1998 the stock markets & the currencies in many of these states had lost
over 70% of their value. To help the economies of these states the International Monetary Fund
(IMF) came up with a massive financial assistance.

Background

The root of the 1997-98 Asian financial crisis were from the previous decade when these
countries were experiencing extraordinary economic growth. Exports had long been the engine
of economic growth in these countries. A combination of reasonably priced and relatively well
educated labor, export oriented economies, falling barriers to international trade, transform many
Asian states into “export powerhouses”. Over the last decade, exports of these states had grown
up to around 15%. The nature of these exports had also shifted in recent years from basic
materials and products such as textiles to complex and increasingly high technology products,
such as automobiles, semi-conductors, and consumer electronics.

CAUSES OF ASIAN ECONOMIC CRISIS:

Investment Reliant On Heavy Borrowing.

The wealth created by export led growth helped to increase an investment boom in commercial
and residential property, industrial assets, and infra-structure. The value of commercial and
residential real estate in cities such as Hong Kong and Bangkok started to rise. Office and
apartment building were going up all over the region. Heavy borrowing from banks financed
much of this construction, but so long as the value of property continued to rise, the banks were
more than happy to lend. As for industrial assets, the continued success of Asian exporters
encouraged them to make ever bolder investments in industrial capacity. An added factor behind
the investment boom in most Southeast Asian economies was the government. In many cases the
government had started huge infra-structure projects. Throughout the region governments also
encouraged private businesses to invest in certain sectors of the economy in accordance with
"national goals" and "industrialization strategy". These investments, always dependent on heavy
borrowings, built up massive debts that were equivalent, on average, to four times their equity. In
Malaysia, the government had encouraged strategic investments in the semi-conductor and
automobile industries. In Indonesia, President Suharato has long supported investments in a
network of an estimated 300 businesses that are owned by his family and friends in a system
known as "crony capitalism". By the mid 1990s Southeast Asia was in the grips of an
unprecedented investment boom, much of it financed with borrowed money.
Declination In The Quality Of Investments.

The large volume of investments ballooned during the 1990s resulted the quality of many of
these investments declined significantly. In addition to, the investments were made on the basis
of projections about future demand conditions that were unrealistic. The result was the
emergence of significant excess capacity.

A building boom in Thailand resulted in the emergence of excess capacity in residential and
commercial property. By 1997 Bangkok’s building boom had produced enough excess space to
meet its residential and commercial need for at least five years.

The Mounting Of Debt.

By early 1997, massive investments in industrial assets and property had created a situation of
excess capacity and plunging prices, while leaving the companies that had made the investments
groaning under huge debt burdens that they were now finding difficult to service.

To make matters worse, much of the borrowing to fund these investments had been in US
dollars. Throughout the region local currencies were pegged to the dollar, and interest rates on
dollar borrowings were generally lower than rates on borrowings in domestic currency.
However, if the governments in the region could not maintain the dollar peg and their currencies
started to depreciate against the dollar, this would increase the size of the debt burden that local
companies would have to service, when measured in the local currency.

Another complicating factor was that by the mid 1990s although exports were still expanding
across the region, so were imports. The investments in infrastructure, industrial capacity, and
commercial real estate were sucking in foreign goods at unprecedented rates. To build infra-
structure, factories, and office buildings, these countries were purchasing capital equipment and
materials from America, Europe, and Japan.

Reflecting growing imports, many states saw the current account of their BOP was running into
the red zone during the mid 1990s. By 1995 Indonesia’ current account deficit was equivalent to
3.5% of its GDP, Malaysia’s was 5.9%, and Thailand’s was 8.1%. With deficits like these
starting to pile up, it was becoming increasingly difficult for the governments of these countries
to maintain the peg of their currencies against the US dollar.

Defaulting & Bankrupting.

The Asian meltdown began in February, 1997 in Thailand. Thai property developer, failed to
make interest payment on eurobond loan, effectively entering into defaulting. The Thai stock
market had already declined by 45% since its high in early 1996, primarily on concerns that
several property companies might be forced into bankruptcy. The stock market fell another 2.7%
later.

Many of the country’s financial institutions including Finance One, the country’s largest
financial institution had pioneered a practice to issue eurobonds denominated in US dollars and
using the proceeds to finance lending to the country’s booming property developers. Finance
One was able to exploit the interest rate differential between dollar denominated debt and Thai
debt (i.e. Finance One borrowed in US dollars at a low interest rate, and leant in Thai Bhat at
high interest rates). The only problem with this financing strategy was that when the Thai
property market began to unravel in 1996 and 1997, the property developers could no longer
payback the cash that they had borrowed from Finance One. In turn, this made it difficult for
Finance One to pay back its creditors.

It was at this point that currency traders began a concerted attack on the Thai currency, the baht.
For the previous 13 years the Thai baht had been pegged to the US dollar at an exchange rate of
around $1=Bt25. Currency traders looking at Thailand’s growing current account deficit and
dollar denominated debt burden, reasoned that demand for dollars in Thailand would rise while
demand for Baht would fall. The value of the baht subsequently falls against the dollar, then
when the trader has to buy the baht back to repay the financial institution it will cost her less
dollars than she received from the initial sale of baht. The trader then exchanges the Bt100 for $4
(at an exchange rate of $1=Bt25). If the exchange rate subsequently declines to $1=Bt50 it will
only cost the trader $2 to repurchase the Bt100 in six months and pay back the bank, leaving the
trader with a 100% profit!

In May 1997 short sellers were swarming over the Thai baht. In an attempt to defend the peg, the
Thai government used its foreign exchange reserves (which were denominated in US dollars) to
purchase Thai baht. The Thai government raised key interest rates from 10% to 12.5% to make
holding Baht more attractive, but since this also raised corporate borrowing costs it only served
to worsen the debt crisis.

As the baht declined, so the Thai debt bomb exploded. Put simply, a 50% decline in the value of
the baht against the dollar doubled the amount of baht required to serve the dollar denominated
debt commitments taken on by Thai financial institutions and businesses. This made more
bankruptcies such as Finance One all further pushed down the battered Thai stock market.

In July the Thai government took the next logical step, and called in the International Monetary
Fund (IMF). IMF loans, however, come with tight strings attached. The IMF agreed to provide
the Thai government with $17.2 billion in loans, but the conditions were restrictive. The IMF
required the Thai government to increase taxes, cut public spending, privatize several state
owned businesses, and raise interest rates – all steps designed to cool Thailand’s overheated
economy. Furthermore, the IMF required Thailand to close illiquid financial institutions.

The International Monetary Fund.

The Asian financial crisis has been the biggest test for the IMF. The original charge of the IMF
was to lend money to member countries that were experiencing balance of payments problems,
and could not maintain the value of their currencies. The idea was that the IMF would provide
short term financial loans to troubled countries, giving them time to put their economies in order.
IMF loans have always come with conditions attached. Conditions attached to IMF loans have
normally required the borrowing country to cut government spending and raise interest rates to
slow monetary growth and inflation.
As a result of the Asian crisis, in late 1997 the IMF found itself committing over $110 billion in
short term loans to three countries; South Korea, Indonesia, and Thailand. With other aid
packages, the IMF loans come with conditions attached. The IMF is insisting on a combination
of tight macro-economic policies, including cuts in public spending and higher interest rates, the
deregulation of sectors formally protected from domestic and foreign competition, and better
financial reporting from the banking sector.

One criticism is that tight macro-economic policies are inappropriate for countries that are
suffering not from excessive government spending and inflation, but from a private sector debt
crisis with deflationary undertones. In Korea, the government critics that the IMF is insisting on
applying the same policies that it apply to countries suffering from high inflation. The IMF is
requiring Korea to maintain an inflation rate of 5%. So to hit a 5% inflation rate, the Koreans are
being forced to apply an unnecessarily tight monetary policy. Short term interest rates in Korea
jumped from 12.5% to 21% immediately after Korea signed its initial deal with the IMF. For its
part, the IMF rejects this criticism. The IMF also argues that by requiring Korea to remove
restrictions on foreign direct investment, foreign capital will flow into Korea to take advantage
of cheap assets. , this will increase demand for the Korean currency, and help to improve the
dollar/won exchange rate.

A second criticism of the IMF is that its rescue efforts are worsening a problem know to
economists as moral hazard. Moral hazard arises when people behave recklessly because they
know they will be saved if things go wrong. By providing support to these countries, the IMF is
reducing the probability of debt default, and in effect bailing out the very banks whose loans
gave rise to this situation in the first place.

The final criticism of the IMF is that is has become too powerful for an institution that lacks any
real mechanism for accountability. By the end of 1997, the IMF was engaged in loan programs in
75 developing countries that collectively contain 1.4 billion people. The IMF was determining
macro-economic policies in those countries. Then the IMF put together a harsh program for
Korea without having deep knowledge of the country.

Effects of the Crisis

Falls in equity markets, foreign exchange markets and rises in interest rates are the most notable
financial effects. These changes then have an impact on the real sector of the South East Asian
economies.
• Equity Markets
Stock markets serve as a barometer of opinion on the health of an economy. The concerns about
the South East Asian economies were reflected in sharp falls in the stock markets in the eight
countries affected. The greater the degree of concern over a particular country’s troubles, the
greater was the consequent correction of its stock market.
The level of any stock market is ultimately dependent upon the prospects for continued
earnings/profits of the companies listed on the market. In crisis periods when economic problems
are taking place, or even anticipated, stock markets would tend to fall to reflect the lower
expected profits. However, when investors lose confidence in the economic health of an entire
economy or a government to meet its foreign debts, they will seek to move funds abroad into
more secure assets. Financial companies which invest in large portfolios will switch from
holding stocks to holding hard currency or bonds issued by the governments of the industrialised
economies, particularly the United States. During periods of financial chaos, such government
bonds are viewed as ‘safe havens’. This ‘flight to quality’ tends to worsen the anticipated
problems.
• Competitive Currency Devaluation
One of the most notable effects of the Asian Crisis has been the rapid fall in the value against the
dollar of many of the region’s currencies. Devaluations can be very contagious as ‘matching’
devaluations are made, moving from country to country.
Following the devaluation of the Thai baht, wave after wave of speculation hit other Asian
currencies. One after another currencies were all marked sharply lower. With its foreign
exchange reserves down to $28 billion, Malaysia declined its currency from $1=2.525 ringgit to
$1=4.15 ringgit in six method time. Singapore followed from $1=S$1.495 prior to the
devaluation to $1=S$2.68 a few days later. Next up was Indonesia, whose currency was devalued
a loss of 75% (from $1=Rp2400 to $1=Rp4000)
• Interest Rates
Another effect of the financial crisis was that interest rates increased significantly. The market
reaction to a decrease in the money supply is an increase in market interest rates and the prospect
of a so-called ‘credit crunch’, in which funds for borrowing diminish throughout the economy.
In addition to this market response, the monetary authorities may raise rates further in an effort
to prevent further, continuous depreciation of the currency. For example, Indonesia raised
overnight interest rates to 300% in August 1997, but this failed to stop the exchange rate from
collapsing. On the other hand, in Thailand during the initial pressure on the baht, the central bank
resisted tightening monetary policy. As a result overnight interest rates peaked at 20%, before
falling back to 10% in August 1997. Although they may be necessary to prevent stricken
currencies going into free-fall, one effect of higher interest rates is to reinforce the deflationary
pressures squeezing the domestic economy.
• The Real Economy
These factors in combination have initiated a severe contraction in real economic activity in
South East Asia, characterized by increased corporate bankruptcies and rising levels of
unemployment. The best up-to-date statistics available (from the IMF) indicate that nominal
GDP contracted in the first half of 1998 by 12% in Indonesia, by 8% in Thailand and by 5% in
Malaysia and the Philippines.
Economic theory predicts that a currency devaluation should lead to an overall expansion of
output, as production for export increases. However, in the worst crises, if devaluation is slow in
triggering an expansion of exports, a contraction in economic activity and deflation ensues.
The combination of high levels of debt, rising interest rates and consumer caution reinforces
weak economic sentiment. In such cases, international trading conditions also become shattered,
further depressing confidence. Given the poor economic prospects globally, currency
devaluations are unlikely to provide much relief in the medium term. This is a ‘debt deflation’.
Implications on Business.
The Asian financial crisis throws the risks associated with doing business in developing
countries into sharp focus. For most of the 1990s, multinational companies have viewed Asia as
a future economic powerhouse, and invested accordingly. This view was not without foundation.
The region is home to 60% of the world’s people and a number of dynamic economies that have
been growing by nearly 10% per year for most of the past decade. This elated view was rudely
shattered by the events of late 1997. It would be wrong to conclude, however, that the impact
upon companies doing business in the region will be purely negative. On closer examination,
there is a silver lining to many of the storm clouds hanging over Asia.

On the negative side on the equation, the Asian crisis will undoubtedly have some painful effects
on companies with major activities and investments in the region’s troubled economies. For
example, the Malaysian government cancelled its $5 billion Bakun hydro-electric damn project.
Similarly, Boeing expressed concern that the Asian crisis may result in as many as 60 orders for
large jet aircraft being postponed or cancelled.

To make matters worse, many Asian companies will now be looking to export their way out of
recessionary conditions in their home markets. This may lead to a flood of low priced exports
from troubled Asia economies to other countries.

On the other hand, firms that source components from Asia have seen a steep drop in the price of
those inputs, which has a beneficial impact on profit margins.

Furthermore, several firms are reportedly taking advantage of the changing circumstances in
Asia to increase their rate of investment in the region. Plunging stock markets across the region
have left many Asian companies trading at prices that are less than their break-up value, while
the IMF’s rescue packages have required Korea, Indonesia, and Thailand to relax restrictions on
inward foreign direct investment. As a result of these factors, it is reasonable to expect firms
from outside of these countries to start buying the assets of troubled companies while they can be
purchased for cents on the dollar. Indeed, there are signs that that is starting to happen. In
December 1997,

Finally, it is worth emphasizing that despite its dramatic impact, the long run effects of the crisis
may be good not bad. To the extent that the crisis gives Asian countries an incentive to reform
their economic systems, and to initiate some much need restructuring, they may emerge from the
experience not weaker, but stronger institutions and a greater ability to attain sustainable
economic growth.