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Economics 3403
Spring, 2001
International Economic Policy
Policy Paper 5
The East Asian Currency Crisis
Keith Maskus
Note: if you find this stuff interesting and want to read more, I suggest you visit the website of Professor
Nouriel Roubini at New York University at www.stern.nyu.edu/~nroubini/asia/AsiaHomepage.html
You’ll find tons of material there and links to other sources. Also you’ll find the IMF publication Finance
and Development: The Asian Crisis, June 1998 to be informative, and The Economist has devoted many
stories to the problem.
1.
Introduction
The fast-growing East Asian developing economies – Korea, Taiwan, Malaysia, Indonesia,
Philippines, Thailand, Singapore, Hong Kong, and China – have greatly benefited from opening to
international trade and financial flows. However, their growing reliance on capital inflows to finance
aggressive development spending in the 1990s exposed deep flaws in the competitive and regulatory
structure of their financial systems. Moreover, such massive capital inflows can be easily and sharply
reversed in the event of a decline in confidence in economic management and in the ability to sustain the
value of the exchange rate.
In a nutshell, this is the source of the Asian (later Russian, now Turkish) crisis: spectacular capital
flows after liberalization, responding to evidently profitable market opportunities, some of which were
actually plagued with cronyism, directed lending, and poor financial supervision and regulation. When
these problems became clear, capital escaped in massive amounts, which has been highly destabilizing.
The so-called “contagion effect” among countries served to highlight weaknesses in several nations.
2.
Origins of the Crisis
When histories of this episode are written, most will probably start with the default on Thai bonds and
devaluation of the Thai baht in mid-1997, or perhaps with the bankruptcies of large manufacturing
conglomerates in Korea in early 1997. But the sources go back before 1997. To me the key originating
factor was the famous Plaza Accord of 1985. Financial officials of major countries met and agreed to
intervene aggressively in foreign exchange (FX) markets to drive down the value of the dollar, which had
appreciated massively in the early Reagan years. The resulting depreciation was large; the dollar went
from around 220 yen (it had been even higher) to 140 yen (around 37%) by year end. It helped kick off the
stock market boom in the US that we experienced until recently.
The real impact was in Japan. The yen appreciation was a big external shock to Japanese exporters.
Manufacturing firms quickly began to shift work overseas by investing in Korea, Taiwan, and SE Asia
because the appreciated yen and high Japanese wages had raised costs too high at home. This investment
rapidly built up manufacturing capacity in Asian developing economies in textiles, metals, semiconductors,
automobiles, and other products. However, because of the “lifetime employment bargain” in Japan, these
firms could not lay off domestic workers. The workers were moved into less productive tasks and middle
management, causing a serious deterioration in efficiency and raising costs.
The Japanese policy response was to offset the contractionary effects of yen appreciation with a highly
expansionary monetary policy in the late 1980s. This rapid monetary growth kicked off a major asset price
bubble in property values and stock prices. The Nikkei stock index rose quickly to 42,000 from around
15,000; land prices in Japan became amazingly high (some people claimed that a square block in the Ginza
in downtown Tokyo was worth more than all of Los Angeles in 1989); Japanese companies and banks used
some of the funds from all this financial activity to buy US real estate, etc. The key thing was the massive
bank lending to buy real estate and stocks. This process was unsustainable and in late 1989 the Bank of
Japan began to prick the bubble with monetary restraint. Asset prices fell a lot in 1990-91, with the Nikkei
index collapsing to about 19,000. It is now at 13,000, 11 years later. Property prices fell more slowly but
they have come down sufficiently that many borrowers have gone bankrupt or are not repaying their loans.
This story is important for three reasons. First, Japanese economic growth slowed considerably in the
1990s and Japan is now in a severe recession (its real GDP fall by about 3.5% in 1998 and is likely to
contract again in 2001). As a result, Japan’s import demand for Asian goods collapsed in 1996-97.
Second, Japanese banks have been placed in a perilous position because all those property and equity loans
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went bad. Estimates now are that non-performing loans exceed $1 trillion, or over 30% of Japanese GDP.
These banks have called in other loans in an attempt to recapitalize themselves, which has resulted in a
general credit decline (a “credit crunch” in the colorful phrase). Essentially no one is borrowing or lending
in Japan now, which is seriously crimping the economy and is now resulting in deflation. Third, to try to
combat recession and deflation, the Bank of Japan has run an increasingly loose monetary policy, bringing
interest rates down to ridiculously low levels. The discount rate is now 0.25% and not long ago was zero.
But still bank lending in Japan has not risen because people and firms don’t want to borrow. And they
shouldn’t, since price deflation implies a high real interest rate (why would you borrow money if prices are
going to fall by 4%, making it more difficult to earn enough to pay off the loan?).
However, these really low Japanese interest rates were greatly attractive to Asian borrowers. Imagine
that you are a banker or company in Indonesia, Korea, Thailand, etc. Through the 1990s these countries
had maintained essentially fixed exchange rates to the dollar. Because they were fixed there wasn’t much
exchange-rate risk as long as the dollar/yen rate was pretty stable. And there was no exchange-rate risk on
borrowing from the US (or from anyone else in dollars), and American pension funds and mutual funds
were also happy to pour money into Asia. All this meant that Asian firms could borrow in foreign
currencies from abroad (US, Japan, Canada, EU) at short-term rates that were pretty low and lend the
money to developers in their countries in local currencies at higher rates. The higher rates reflected some
controls on interest rates and a small (too small, we now know) risk premium. These internal loans could be
fairly easily serviced so long as exchange rates were stable and there was high economic growth. Indeed, it
was a pretty good investment for foreigners, who saw no problems being repaid (and many of them lent
directly to local enterprises at the higher local rates). Foreign fund managers and banks were eager to
comply and there was a nifty “Emerging Market Craze” in 1994-95. As a result, there were massive shortterm capital inflows, reaching $38 billion in Korea in 1995, for example. This process worked in Korea,
Thailand, Philippines, Indonesia, Malaysia, Hong Kong, Singapore, and Taiwan. In any event, all this
borrowing had two structural problems: a maturity mismatch (short-term foreign borrowing and long-term
local lending) and a currency denomination mismatch (external borrowing in foreign currencies and local
lending in domestic currencies).
Some of that investment went to serious, productive uses that supported repayment of the loans. But
much of it went instead into real estate speculation, questionable construction projects that overbuilt cities,
government transfer payments, and outright corruption. A considerable amount of all this lending through
local banks was directed by governments to favored opportunities. Governments generally treated banks as
fiscal agents for particular programs without requiring adequate risk or profitability assessments. Consider
one example – by 1994, over 40% of Korea’s bank loans were to property developers, a ridiculously high
figure.
One effect of all that was to promote property and real estate booms in Seoul, Taipei, Jakarta, Manila,
Kuala Lumpur, Bangkok, and Hong Kong. If you’ve traveled to any of these cities you’ve seen the
extraordinary growth in construction of hotels, office buildings, retail centers, and so on. This generated
congestion, traffic headaches, and costly residential rents and prices in addition to making many people feel
richer on paper. It is one reason why the Indonesian economy was able to move so many poor people into
their “middle class” in the 1990s. It is ironic, then, that the Japanese monetary expansion of the 1990s has
basically fueled property speculation in East Asia.
China is going through a rather similar process now, though it is less exposed to foreign borrowing.
The obvious question is how could all of this happen without foreign investors paying enough attention
to the possible risks? Surely one reason was the euphoria (“irrational exuberance”) that accompanied herd
investment instincts in growing markets. But there are two other deeper reasons.
First, lending in many developing economies is not transparent (it’s not transparent in Japan, either).
American mutual funds lending to a bank or buying government bonds probably paid too little attention to
what those funds were actually used for, but it was difficult to find out in any case. Lending was often
made to questionable and murky borrowers without sufficient supervision. Generally speaking, Asian
banks have very low capital-adequacy standards. Much property lending was unsecured without collateral.
And often banks were little more than shells to direct money to favored interests (consider the Suharto
family in Indonesia, Prime Minister Mahathir in Malaysia, the Korean chaebol conglomerate firms, and the
free-wheeling Thai land speculators). Bank supervision and information releases were virtually absent.
Bank authorities have no clear rules about whether they can close down insolvent institutions and how to
go about it. And bankruptcy laws for banks, companies, and others are weak and do not work well.
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All of this adds up to a lot of hidden risk (the problems are similar but more severe in Russia). Clearly
much lending happened without enough information and knowledge, so it was no surprise when so much
disinvestment occurred when all these problems were exposed.
A second, and very powerful reason is that investors actually thought there was not much risk in Asia,
so there was not much need to be vigilant about it. In part this is because investors generally believed that
Asian governments would bail out banks and major companies, not allowing them to fail (default on
foreign debts). More fundamentally, investors believed that the IMF and developed-country governments
would also step in to cover creditor losses in the event of default. Most economists trace this confidence to
the US-IMF response to the Mexican peso crisis of 1994-95. The Mexican government ran a very
expansionary policy in 1994 to ensure re-election of the ruling party (the PRI). But they also refused to let
the peso fall even as it became clear that the Mexican current account deficits were rising quickly and
becoming unsustainable (up to 6.5% of GDP). There was massive speculation against the peso in late 1994
and ultimately the peso was allowed to float in December, 1994. It plunged in value and the country went
into crisis; it is still emerging.
The US arranged a $30 billion rescue package to restore Mexican FX reserves and promote more
stability in the peso because we saw two problems there. One was that the exchange rate and price
instability, along with declining real incomes of Mexican workers, were placing greater pressures on
migration and also threatened to destabilize NAFTA. That was a good reason to intervene. The second
was that there were significant potential losses for US holders of Mexican bonds and debt instruments and
these investors lobbied hard for stabilizing the economy before their loans were defaulted on. This was not
a good reason to intervene, because it generated a generalized expectation among investors that emerging
economies in trouble would be bailed out. This amounted to a moral hazard problem, in that it encouraged
lenders to underprice risk in emerging economies in the belief that they would be bailed out. There is
considerable truth to this story because risk assessments in Asia and Russia were clearly too optimistic.
3. The Crisis Erupts
All of these things – massive borrowing, corrupted lending, non-transparency, and inadequate attention
to risk – could go on without much disruption as long as economies were growing rapidly and exchange
rates were reasonably stable. But things fell apart in 1996-97. Export growth rates of the Asian developing
economies fell dramatically in 1996 because of the Japanese recession and because the yen depreciated
heavily against the dollar (as it had to given the unsustainably high levels of the yen in 1995, when it
reached a peak of 82 yen per dollar). The yen depreciation made the Asian currencies seem expensive in
comparison because they were fixed to the dollar and also appreciated relative to the yen. Moreover, many
of these Asian economies were experiencing high domestic inflation rates because of the property booms,
meaning that in PPP terms their currencies were becoming overvalued. A final reason for the export
slowdown was that the early 1990s were a period in which considerable excess capacity in manufacturing
was built in Asia. This was especially true in semiconductors, which continue to experience a global
production glut, but also was the case in chemicals, steel and other metals, shipbuilding, and food
processing, among others. This excess capacity is one reason for continuing price deflation in Asia.
It became clear in early 1997 that growing current account deficits were becoming large and
unsustainable. For example, in 1996 those current account deficits were around 8% of GDP in Thailand,
6% in Indonesia, and 7% in Korea. As a rule of thumb, albeit a weak one, a CA deficit in excess of 3.5-4%
of GDP is considered “unsustainable” in that it generates massive financing requirements and puts
downward pressure on the currency. When investors saw these problems developing they took a much
closer look at the quality of their investments in Asia and began to realize that they were heavily exposed to
a risk of local currency devaluation, bankruptcies, and default.
Indeed, in early 1997 real signs of distress were evident in domestic business sectors. For example, in
February, Hanbo Steel, one of the largest Korean conglomerates, declared bankruptcy and defaulted on its
bank debt. This was a great shock to the Korean financial system, which began calling in its loans and this
put rising pressure on the by-now quite uncompetitive and costly manufacturing firms. The first wave of
speculation hit the Thai baht in April and May, where it had become clear that huge amounts of property
loans could not be repaid and were subject to default. Foreign exchange traders began to “sell the baht
short” in expectation of its devaluation. (A brief course in finance: to sell an asset short means that you sell
it today and simultaneously agree to buy it back in the future in the expectation that it will be cheaper when
you buy it back. For example, suppose the current exchange rate is 10 baht per dollar. I could sell 10
million baht now for $1 million and commit myself to buying back the 10 m baht in 30 days. If over 30
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days the baht depreciates to 7 baht per dollar, my cost will be $700,000, leaving me a profit of $300,000.)
The Thai government defended the baht for two months by spending its foreign reserves to prop up the
baht. Thailand’s FX reserves fell from $37 b in 1996 to a low of $24 b in July 1997. Thailand also raised
domestic interest rates to high levels (18-21% in money markets) to attract sufficient foreign investment to
remove the pressure on the baht. It didn’t work and Thailand had to allow the baht to float in late June.
The baht fell from a nearly-fixed rate of 25 baht/$ to 55 baht/$ in January 1998 (it has recovered to about
45 baht/$ currently). This rapid depreciation meant that Thai banks found it virtually impossible to service
their short-term foreign loans and there was massive default, including default on some government bonds.
The Thai default resulted in an IMF rescue package, made up of the usual IMF components for a
“stabilization program”. It is worth understanding the basic IMF conditions that are imposed on a
developing country in financial distress:
1. significant depreciation of the home currency in order to turn the CA deficit into a CA surplus (by
bringing down imports and raising exports) and restore credibility in the ability to attract funds;
2. monetary contraction to offset the inflationary effects of the currency depreciation and also to
reduce demand for imports;
3. government budget cuts to reduce or eliminate budget deficits, thereby reducing the government’s
need to borrow external and internal funds that might be channeled into private borrowing;
typically this means ending food subsidies, reducing transfer payments, and stopping
infrastructure building programs.
In return for meeting such conditions, the IMF arranges large amounts of short-term financing to restore FX
reserves and permit some servicing of foreign debt. The severity of the conditions imposed depends on
how unstable the financial picture is along with how significant the damages might be for local consumers
and businesses. They were pretty severe in Thailand.
This program was met with the usual complaints from both conservative economists, who tend to
favor rigidly fixed exchange rates, and liberal economists who think the IMF should impose weaker
conditions and also arrange for stronger development assistance and construction and maintenance of
“social safety nets”. (Another aside – few developing countries, even in relatively well off East Asia, have
social security programs, unemployment compensation, re-training assistance, or even anti-poverty food
provision programs. So a massive currency devaluation can be devastating to the poor because it raises
inflation and makes it quite difficult to import basic foodstuffs.) Many foreign investors lost money
because the stream of baht earnings on local loans was not enough to pay off loans in now much more
expensive dollars and yen. Despite all these problems, however, it seemed the IMF had contained the Thai
problem by end of July.
However, unlike earlier exchange crises (there were many banking and exchange crises in
developing countries in the 1990s), something new and powerful happened this time – the so-called
“contagion effect”. Investors considered Thai distress to be a “wakeup call” that caused them to look
closely at similar financial sector weaknesses in other Asian economies. Quickly there emerged pressure
on the currencies of Indonesia, Malaysia, Philippines, Hong Kong, and Taiwan. Indeed, this pressure was
sensible because the baht depreciation mean the Indonesian rupiah and the Malaysian ringgit, etc. had
become even more costly relative to a key competing currency. Currency speculation emerged in many
markets and, even though each country tried to defend its exchange rate with sales of reserves and high
interest rates (eg, the money market rate in Indonesia reached a high of 65% in August), Indonesia,
Malaysia, and the Philippines had to float their currencies by September. Indonesia in particular has
experienced a massive depreciation of the rupiah since then, from 2600 R/$ in July 1997 to over 10000 R/$
in January 1998; it is currently trading at 11000 R/$. A brief description of what happened in other
countries is useful:
1. Malaysia experienced a smaller depreciation (from 2.5 ringgit/$ fixed rate to around 4 r/$
floating rate). In summer 1998 the Malaysian government fixed the rate at 3.8 and imposed
significant controls on capital flows, effectively ending convertibility of the ringgit.
2. The Philippine peso went from 26 P/$ quasi-fixed rate to 42 P/$ flexible rate; it is now
floating with a rate of around 50 P/$.
3. Singapore experienced a relatively mild depreciation from 1.4 S$/$ to current rate of 1.6S$/$.
4. Taiwan disappointed its Asian export competitors when, despite its huge stock of foreign
reserves, which were not under much pressure, it devalued the NT$ from around 28NT$/$ to
its current rate of around 32 NT$/$. Taiwan did this as a defensive competitive measure on
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behalf of its exporters, but many Asian scholars think it threw additional pressure into Asian
exchange markets.
Hong Kong never allowed a devaluation and maintains a fixed rate of 7.7 HK$/$. This
approach has made HK seem a stable place but it has placed severe contractionary pressure on
the Hong Kong economy, for to maintain the fixed rate in the presence of downward pressure,
the government has had to raise interest rates and sell foreign reserves. HK’s unemployment
rate hit an all-time high in 199 and property values plunged; it is mildly recovering now.
China has also maintained a policy of keeping the yuan (renminbi) fixed at around 8.2
Yuan/$. Unlike the HK$, the Yuan is not completely convertible and there are rigorous
capital controls in China, which has made it easier to sustain the yuan. However, the yuan
became increasingly expensive in real terms relative to its Asian competitor exporters and
there was a considerable expectation that China would devalue the Yuan in 1999. It did not,
showing that China's leaders place a huge premium on economic credibility.
South Korea thought initially that it would escape the problems in Southeast Asia, because it
is a bigger and more advanced industrialized economy. However, uncertainty surrounding the
presidential election in late 1997, plus the obvious fragility of the banking system and the
losses piled up by the manufacturing conglomerates, caused investors to flee the won in
October and November. The won fell from 892 won/$ in July to nearly 1700 won/$ in
December 1997. It is currently trading at 1325 won/$.
This contagion was not the only unusual aspect of the crisis. A second is that the central developed
country in the region, Japan, was also in crisis and could not be counted on to increase its spending and
offset the export contraction. This is very different from the Mexican peso crisis, when Mexican exports to
the U.S. rose considerably after the devaluation, helping Mexico begin its recovery. As long as Japan is
mired in recession, this will be a difficult problem to overcome. A third aspect is that as crisis spread
throughout East Asia, foreign and domestic banks became less willing to make new loans, resulting in a
generalized credit contraction. This is perhaps the most significant difficulty on a global scale.
The IMF tried to deal with these problems by arranging rescue packages in the Philippines, Korea, and
Indonesia. Indonesian negotiations are still ongoing in the face of occasional riots aimed at reducing the
power of Indonesian cronyism, restoring food and fuel subsidies, and opening up democratic processes.
The IMF programs seem to have restored some stability for the time being. But it is argued by many that
the IMF conditions have worsened recessions, raised poverty, and placed contractionary pressures into
fiscal and monetary policy at a time of serious distress.
I should note in passing that the Asian crisis has not been good news for primary commodity exporters
with large markets in Asia – Australia, New Zealand, and Canada in particular (not to mention US farmers
and oil exporters like Russia, Mexico, and Venezuela). All of those countries have significant portions of
their export sales aimed at Japan and developing Asia. This has resulted in a dual problem. First is simply
declining demand in Asia, so their export volumes have fallen. Second is that the lower demand has also
dramatically reduced global commodity prices. World prices for oil, minerals, and agricultural crops
(wheat, corn, cotton, rice, rubber, etc.) are now near their lowest real levels since 1960. From levels of
around 1.25 per $ pre-crisis, the Canadian $ has fallen to 1.55 C$/$; the Australian dollar to about 2.0 A$/$,
and the NZ dollar to about 2.5 NZ$/$. While these cheaper currencies have helped reduce the problems
from lower Asian demand, those countries experienced significant recessions until recently.
4. Lessons to be Drawn
It is important to use this negative experience to think about problems with the global financial system.
These are very complex issues and there is not a lot of consensus among international economists about
what should be done in the future. While many conclusions could be reached, I think I will list three that
are sensible to me and refer you to other publications for more information (see the Roubini website
mentioned above; try also Morris Goldstein, The Asian Financial Crisis, Institute for International
Economics, 1998).
First, it seems clear that financial market liberalization (allowing unimpeded short-term capital flows)
must be accompanied by sensible financial regulation, involving requirements for information disclosure,
transparency in lending and accounting, effective bank supervision, appropriate and timely classification of
non-performing loans, and so on. It is highly risky to permit free capital mobility in the presence of lousy
capital adequacy standards. This calls for developing countries not to shut themselves off from capital
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markets but to adopt modern fiscal standards as practiced in developed economies. Note this is a key
example of “deep integration” of economies, which is often opposed on grounds of national sovereignty,
but it is important to move in that direction. It would provide a role for the IMF to play as a pro-active
watchdog or rating agency that could give early warning signals of financial difficulties and could increase
information flows to investors. The IMF’s current approach of reacting to crises after the fact is becoming
increasingly outdated.
Second, there must be a way to reduce the moral hazard problem in international lending. This calls
for a fundamental restructuring of the IMF and its procedures. We could take a page from how the US
system works and suggest two changes. For one the IMF would have its role redefined to conduct
monitoring and surveillance and also to act as a global lender of last resort in the event of a generalized
credit contraction across countries. When a significant number of countries find themselves in crisis with
banks shutting down lending activities, there is a good argument for having the IMF step in with additional
liquidity to help restore confidence. To combat moral hazard, we could then establish a complementary
organization (privately funded, if possible) that would sell insurance to investors who wished to get into
emerging markets. Those who buy such premiums would have access to better risk assessments and would
be insured against losses (depending on how much insurance they buy). Those who choose not to go
through this route would be fully subject to risk and in the event of losses neither this new agency nor the
IMF nor national governments should feel any obligation to bail them out.
Third, and more broadly, I would argue that developed countries should go back to a more benign
attitude toward foreign aid. The US seems to believe that we can substitute liberal markets (“trade and
finance; not aid”) for effective development assistance. Such assistance from the US has reached historic
lows. In return for providing more aid, developed countries would be right to insist on transparency,
removing corruption, and requiring structural economic reforms. However, reform of financial and product
markets is a tough, long process that requires years of effort and commitment. We should not imagine that
simply pushing for financial market liberalization (even with its competitive benefits) would accomplish
this overnight. In the short term it exposes economies (and especially the poorest people in those
economies) to heavy volatility in exchange rates and prices. Thus, I would argue for an expanded program
of debt relief, technical assistance for economic reform, and further aid aimed at developing basic social
safety nets.
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