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From the 1960s to 1990s the performance of the East Asian economies was somewhat spectacular. Their global share of GDP was consistently increasing against the rest of the world, almost doubling in the space of 30 years to around 22.5% in 1990. However, there were apparent weaknesses in their financial structure which can partly explain the cause of 1997 East Asian Financial crisis.
Success story
Until 1997 the countries of east Asia had very high growth rates
The ingredients for their success included but were not limited to: High saving and investment rates, a strong emphasis on education, a stable macroeconomic environment, freedom from high inflation or economic slumps and a highs share of trade in GDP.
Weaknesses
The main weaknesses that became apparent were:
Productivity – Rapid growth of inputs yet little increase in the productivity rate (little increase in output per unit of input)
Banking regulation – poor state of the banking regulation
Legal framework – lack of a good legal framework for dealing with companies in trouble
The Crisis
During the 1990’s there was lots of speculation on the Thai baht as property markets were heating up. After running out of foreign reserves Thailand had to float their currency, cutting its peg to the US $. The crisis started on July 2, 1997 with the collapse of the Thai baht. The sharp drop in currency was followed by speculation against the currencies of Malaysia, Indonesia, Philippines and South Korea. All of the afflicted countries sought out the IMF for assistance apart from Malaysia.
Debt-to-GDP ratios rose drastically as exchange rates fell. Interest rates of 32% in the Philippines and 65% in Indonesia over the crisis did nothing to calm investors and both countries saw a greater percentage decrease in GNP and exchange rate (against the US $) than South Korea.
It was not exactly clear what sparked the ignition of the crisis. The first major corporate failure was in Korea when Hanbo steel collapsed under huge debts. This was soon followed by Steel motors and Kia motors which meant problems for local merchant banks who had borrowed from foreign banks.
Local banks were hit with: withdrawal of foreign funds, substantial foreign exchange losses, sharp increase in NPL’s (non performing loans) and losses on equity holdings.
Pilbeam argued the crisis was due to the banking system and its relationship with the government and corporate structure rather than macroeconomic fundamentals.
The countries wanted high economic growth and so applied pressure on firms to make large investments and on domestic banks to lend to firms. These domestic banks failed to assess the risks properly and financed the loans from residents, foreign banks and investors. These loans were also guaranteed by the government. Overall the banking system was weak, with poor regulation, low capital ratios, poor selection schemes and corruption. Thus the banks lent to firms without a regard for profitability, explaining the large number of non performing loans.
The downturn of the crisis was ‘V-shaped’ – after the sharp output contraction in 1998, growth returned in 1999 as depreciated currencies spurred higher exports.
External Factors
Japans recession through 1990’s – kept interest rates low which allowed for East Asian economies to easily finance excessive investment projects.
50% devaluation of the Chinese currency in 1994 – can partly explain the loss of cost competitiveness from the East Asian economies
Financial deregulation and Moral hazard – attracted foreign banks to invest, more so because of the government guarantee which allowed for the banks’ reckless loan making.
Sharp appreciation of the dollar from mid 1995 – led to deterioration of economies who had pegged their currencies to the dollar. Given time lags between exchange rate effects and trade, this began to affect their export performance in 1996/97.
The IMF
Objectives: prevention of default, prevention of free fall exchange rate, prevention of inflation, maintenance of fiscal discipline, restoration of investor confidence, structural reform of financial sector and banking system, structural reform of corporate sector, rebuilding of foreign reserves, limiting the decline of output.
At their disposal they had the following tools: bank closures, fiscal/monetary discipline and structural reform of the banking and corporate sector.
Did the policies work?
Policies were harsh and depend crisis
Closure of banks reduced credit and created panic for international investors which led to bank runs
Higher interest rates and tighter fiscal policy reduced output. The tight fiscal policy was viewed as harsh considering most countries were already running a fiscal surplus.
There is an argument that knowing the IMF was there to help could have worsened the problem of moral hazard.
Post crisis?
Output fell and there was a fiscal deficit. The current account improved, due to fall in imports and rise in exports after devaluation. Savings increased and investment fell. Overall the recession was short and the economies recovered quickly. This was largely to do with the boost in exports caused by the devaluation.
A World of Economics 