Download South East Asia before the Crisis

The 1990s faced a lot of financial turbulence like the near-breakdown of the European
Exchange Rate Mechanism in 1992-93, the Latin American Tequila Crisis following
Mexico’s peso devaluation in 1994-95 and then the Southeast Asian currency crisis of
1997.
The Asian crisis started with Thailand devaluing its currency in July 1997, reached
neighboring countries (Malaysia, Indonesia, Philippines, and South Korea) by the end of
the year, and then spread to Russia in 1998 and to Brazil in 1999. Even though the
causes of the crises varied in each country, the Tequila Crisis and the Asian crisis have
been defined as twin crisis that is when currency and banking problems are linked
together. This is more severe than when currency and banking problems occur
separately.
The economic effects of this exchange rate instability had a devastating impact on Asia.
The crisis-hit countries of Thailand, Malaysia, Indonesia, the Philippines, and South
Korea experienced a plunge in the external value of their currencies and a sudden
reversal of private capital flows. Investors had poured massive amounts of funds into
the Asian countries until the first half of 1997, and then drastically reversed the pattern
as money flowed out at a staggering pace. The ensuing $100 billion net capital outflow
represented a sizable shock to the region, accounting for 10 percent of the combined
GDP of the five crisis-hit countries.
South East Asia before the Crisis
The countries which witnessed the crisis had shown a spectacular economic growth for
the last two decades before the currency crisis. These countries namely Korea,
Singapore, the Hong Kong Special Administrative Region (SAR), Taiwan, Thailand,
Indonesia, Malaysia and the Philippines were known as the Asian Tigers. These
countries were a major recipient of private capital flows.
However, in 1996, the slowdown of a slowdown of exports and macroeconomic
performance started to raise doubts. After years of double-digit growth, export growth
slowed, and some countries experienced large current account deficits. The main
problem faced by these countries was ‘Over heating’.
Growth in the late 1980s was export-led and resulted in severe labour shortages that
led to sharp rises in real wages. Average nominal wages in manufacturing doubled
between 1987 and 1991 in Korea, and they rose 60% in Taiwan. These rapid wage
increases increased the growth of private consumption. The problem for these countries
was to accommodate rapid increases in consumption as well as rapid increases in
investment and to alleviate the consequential inflationary effects. Before the crisis, they
were relatively successful in curbing inflation, as shown in table below.
Before Crisis (1996)
Causes of the Asian Crisis
Following are the factors identified that made South East Asia susceptible to financial
crisis.
 Unsustainable Current Account Deficits
Most of the South East Asian economies in crisis had large current account deficits
in some cases exceeding 5% of their GDP. These deficits were financed by
attracting inflows of capital from abroad, often short-term capital.
There were concerns regarding opening the capital account. They were:

Capital mobility the national authorities will lose control over monetary policy to
some extent , and the economy will become more vulnerable to external shocks

full capital mobility will result in ‘over borrowing’ and, eventually, in a major debt
crisis

liberalization of capital movements will relate to increased real exchange rate
instability, and loss of international competitiveness

premature opening of the capital account could lead to massive capital flight
from the country
Current Account Positions of the Asian Crisis Economies
The table below shows the size of the capital inflows into the Asian Crisis economies.
Capital inflows from the private sector are broken down between foreign direct
investment (FDI) and portfolio investment in financial markets.
Asian Economies' Capital Flows as a Proportion of GDP (in percentage)
 Over-Dependence on Short-Term Foreign Funds
A large part of their capital inflows consisted of loans banks were motivated by the
prospect of large profits, especially as they could take advantage of fixed exchange
rates in order to reduce the cost of this borrowing. The same motives led blue chip
companies to borrow excessively from overseas, rather than pay higher domestic
interest rates.
Exposure of Banks from Western Countries to Asia: June 1997 (in $ billion)
 Poor Regulation of the Economy
There was an absence of an adequate regulatory framework for businesses and
banks in South East Asia. Banks were unregulated –

loan classification and provisioning practices were very lax

there was too much ‘connected lending’ to bank directors, managers and
their related businesses

there was excessive government ownership or involvement in the institutions

the quality of public disclosure and transparency requirements was also poor.
 Over-Inflated Asset Prices
Owing to the fact that the money supply was growing too quickly for the real
economy to absorb, there were unrealistically high asset values in most of the South
East Asian countries.
In Asia the excessively risky lending fuelled asset price inflation, creating vicious
circle. Risky lending drove up the prices of risky assets, which made the financial
condition of the intermediaries seem sounder than it was, which in turn encouraged
and allowed them to engage in further risky lending
 Fixed Exchange Rates
The governments of the Asian Tiger unofficially fix the value of their currencies to the
dollar. This is said to be the policy error which has also been the cause of the crisis.
Pegging domestic currencies to the dollar had important effects.

In 1995, following the Dollar appreciation especially against Japanese Yen,
the South East Asian countries also appreciated their currencies. The
consequences were substantial losses in competitiveness, with adverse
effects on net exports and growth. The exports with their second largest
trading partner that is Japan were affected adversely. Not only were these
countries running large deficits, but that their strong currencies made it harder
to fund them.

The banks followed risky borrowing strategies because they could not believe
there was any danger of devaluation relative to the dollar taking place.
Furthermore, they did not hedge their foreign currency borrowing.
The Twin Crisis
The currency and banking crises in emerging markets should be seen as twin events,
as they can generate a vicious circle by amplifying each other.

A currency crisis has an adverse effect on the banking sector when banks’ liabilities
are denominated in a foreign currency. Devaluation sharply increases the value,
expressed in the domestic currency, of these liabilities. As banks typically lend
domestically in the local currency, devaluation exposes them to a large amount of
currency mismatch and a deterioration of their balance sheets.

A banking crisis can lead to a currency crisis as it is associated with the worsening
of the fiscal position of a country. This is due to the fact that the cost of addressing
the consequences of a banking crisis, such as the liquidation of insolvent banks, is
borne by the public sector. So there is a drastic change in effective public liabilities
which can trigger expectations of monetization of the fiscal deficit and exchange rate
depreciation.

Supervision and regulation of financial intermediaries in the process of capital
market liberalization is also very important. Like in the case of the Asian Crisis, the
reduction in borrowing costs due to financial deregulation led the banks and firms to
borrow extensively in foreign currencies, and funnel the funds toward the acquisition
of highly risky assets. Therefore, lack of supervision during the liberalization
increased the Southeast Asia’s vulnerability towards the crisis.

The banks in Asia engaged in excessively risky borrowing and investment as they
expected that the authorities to intervene in the event of massive financial distress.
Therefore, a fixed exchange rate regime is intrinsically was unstable and contained
the seed of its own collapse because the apparent stability of the exchange rate peg
led the financial intermediaries to overlook currency risk, and induced them to
borrow heavily in foreign currencies without hedging their exposures.
Contagion
Financial contagion refers to the transmission of a financial shock in one entity to other
interdependent entities. For instance, the devaluation of the Thai baht in July 1997 was
followed by currency crises in Malaysia and Indonesia within a month and in Korea a
few months later. Transmission of a crisis can happen the following ways:

Trade linkages can transmit a crisis, as a currency depreciation in one country
weakens fundamentals in other countries by reducing the competitiveness of their
exports

Financial interdependence can also contribute to the transmission of a crisis, as
initial turmoil in one country can lead outside creditors to recall their loans
elsewhere, thereby creating a credit crunch in other debtor countries

a currency crisis in one country can worsen market participants’ perception of the
economic outlook in countries with similar characteristics and trigger a generalized
fall in investors confidence.

This may also happen if the countries display similar elements of domestic
vulnerability. The Asian countries shared common features such as a high reliance
on foreign denominated debt and a relatively stable exchange rate against the U.S.
dollar.