East Asia Crisis of 1997 Econ 7920 October 8, 2008 Team 5 Bryan Darch Svend Egholm Paramdeep Singh Sarah Zullo
The East Asian currency crisis of 1997 caused severe distress for the countries of East Asia and had a ripple effect that threatened the entire world economy. This challenged the understanding and implementation of macroeconomics principles by the Tigers a term coined by economists for rapidly growing East Asian economies. There was a plethora of interconnected factors that, in conjunction, brought trouble to many economies located in East Asia. Leading up to the beginning of the crisis in July 1997, the economies of East Asia were booming, and high interest rates attracted foreign investors looking for big returns. The liberalization of the economy, by way of opening of various sectors to foreign investment, was cited as the ideal case study for growth by economists the world over. However, these boom times were not sustainable because prior speculation and excessive credit had created over-priced assets. Too large a money supply coupled with inefficient policies and a lack of regulatory measures set the economies up for a colossal collapse. A major devaluation of currency followed, and the crisis began. Until the crisis began in July 1997, the economies of East Asia, with Thailand, Indonesia, Malaysia, the Philippines, Hong Kong, Singapore, and South Korea as the major players, were experiencing rapid growth, by as much as 12% of GDP, and investment. The phenomenal growth is sometimes referred to as the East Asian Miracle. The economies of Southeast Asia maintained high interest rates, which were attractive to foreign investors looking for high returns. Because of this, the region experienced an increase in money supply through large inflows of investment dollars. Additionally, credit was readily available, and this led to a dramatic run-up in asset prices. In the years immediately preceding 1997, the perception of production growth was very high, but in reality the total factor productivity had only seen marginal growth. A true increase in output could have prevented the crisis had it matched the expectations of investors. However as output slowed, capital continued to flow into East Asia undeterred. The perceived growth and its resulting demand outpaced actual production. The economies were overheating, as were the expectations of foreign investors. The expectations of foreign investors, East Asian governments, and eventually the International Monetary Fund, played a large role in the East Asian Crisis. Unprecedented GDP growth, financial liberalization, and deregulation of East Asian central banks blinded investors and much of the world, to potential instability. In reality, debt levels in several countries, including Thailand, Indonesia and South Korea, had climbed past the $100 billion mark. This was not apparent to many investors in part because of the lack of transparency in their home financial market. The economy of Thailand had developed into a bubble, which was fueled by a rapid inflow of money to the economy. Prior to 1997, the general consensus of policy makers in many developing countries was that the best and most rapid way to grow was through opening up their economies to foreign capital inflows. By the mid-1990 s, Thailand, Indonesia, and South Korea had large private current account deficits, and the policies of fixed exchange rates encouraged external borrowing, and this led to foreign exchange rate risk. Around the same time, the U.S. economy was recovering from a recession, and interest rates had been increased to control inflation. This made the U.S. a more attractive place to invest relative to Southeast Asia, as the value of the U.S. dollar was increasing. Many East Asian economies had their exchange rates pegged to the U.S.
dollar, and their exports became less competitive. For instance, Thailand s baht was pegged to the dollar at 25 baht/dollar, so as the dollar increased in value in the late 1990 s, Thailand s exports increased in price and their exports were in less demand. As a result, South Asia s export growth slowed, and their current account positions deteriorated. Because there were large amounts of credit available, asset prices increased to an unsustainable level. As these asset prices began to collapse, people and companies began to default on loans. Because of future expectations by lenders of increased defaults, they began withdrawing credit, which led to a credit crunch and bankruptcies. In addition to lenders withdrawing credit, investors began withdrawing their money based on negative expectations, and the exchange market became flooded with the currencies of these failing countries, causing a depreciation of their exchange rates. To understand just how the quickly and drastically the tide turned, consider these figures: In the first half of 1997, $70 billion of foreign investment entered emerging Asian nations; in the second half of 1997, over $100 billion poured out of these same countries. To prevent a complete collapse of currency values, the governments of these countries were forced to raise interest rates to high levels in an attempt to slow the withdrawal of capital making it appear more attractive. The governments were also forced to buy any excess domestic currency at the fixed exchange rate with foreign reserves. When these governments realized that the outflow of capital was not going to stop, they dropped their policy of fixed exchange rates, thus allowing their currencies to float. This resulted in severe devaluations in their domestic currencies. In turn, liabilities held in foreign currencies became more expensive, thus deepening the crisis. The government of Thailand especially, was attempting to manipulate its currency valuation by spending its foreign reserves in an attempt to prop up its own currency. Because they were spending more of their reserves than they were able to buy back, they eventually ran out and contributed to the currency devaluation. When Thailand s government announced on July 2, 1997, that the value of the baht was going to float, it set off a cascade of economic woes in the region. The baht devalued sharply overnight and lost fifty percent of its value by January 1998. Indonesia s economy took the next hit. Many businesses in Indonesia had funded growth in US dollars. When the crisis hit the summer of 1997, corporations tried to protect themselves by selling rupiah and buying dollars, accelerating the devaluation of the rupiah. South Korea s large corporations were also heavily leveraged and many failed in the wake of the crisis. Philippine s central bank responded to the crisis by raising interest raises, which were already elevated, even higher with the hope of not losing investors. The attempt was not successful and the peso devalued sharply. Prior to July 1997, there were very high hopes for Mayasia, reflected in the fact that their stock exchange was one of the busiest in the world. Malaysia s stocks and currency markets crashed soon after the crisis began. With so many economies faltering in rapid succession, the International Monetary Fund finally intervened in the form of bailouts and new regulations for the affected nations. Many criticize the actions by the International Monetary Fund. According to Keynesian economics, a key way to get out of a recession is to maintain government spending. People are hesitant to invest when there is a downturn in the economy, but investment is still required. Governments are seen as the best group to maintain investment, as they are typically the only ones with money in a recession. In times of recession, Keynes even felt that running a deficit was acceptable as long as the spending was stimulating the economy. When the IMF stepped into the
East Asian Crisis, they pushed for tighter monetary and fiscal policy, which only served to promote the recession. The IMF did not directly attack the massive deficits that were the root cause of the East Asian crisis. Instead, their actions included raising interest rates, cutting government budgets and creating stringent regulations with the hope of regaining investor confidence. However, the countries most involved suffered permanent currency devaluations, massive numbers of bankruptcies, collapses of entire sectors of once booming economies, real estate busts, high unemployment, and social unrest. IMF applied the policies of the Mexican peso devaluation to East Asian countries, without understanding the economies and culture. The East Asian crisis had a far reaching and lasting impact on the global economy. As mentioned earlier, prior to 1997, foreign capital was poured into developing countries without restraint on the side of the investors or the country s government. Following the crisis, investors were hesitant to invest in developing countries, slowing down growth in many emerging markets. Many developing countries faced economic slowdowns as a result, and previously promising economic regions, such as South America, faced crises of their own. Due to what was largely viewed as their ineptitude handling the crisis, the IMF lost a great deal of influence, particularly in emerging economies. To prevent a repeat of the situation and to free themselves from dependence on the IMF, many South East Asian nations built up their foreign exchange reserves. Because many large and small businesses folded, people lost work. The credit crunch made acquiring funding and loans for small businesses and individuals a challenge. The GDP gains that had been made in the preceding decade were essentially erased by the crisis. Per capita income decreased in the affected countries, increasing poverty rates and unemployment. Economic instability led to political instability and a change in leadership in many countries, as was the case in the Phillipines and Indonesia. Although, East Asian economies suffered, China survived and this served as a lesson for economists. China had even a bigger foreign capital inflow (50 billion USD in 1997 against 1.7 billion USD in Thailand). However, the composition of the investment was different. Whereas China had 95% of its investment as FDI in projects, with lock-in periods, Thailand had 50% as portfolio investment without lock in. In other words, China had 95% as long term debt and Thailand had only 50%. The capital outflow was much less in China than these countries. China, in 1997, had 110% of the total debt as reserves while Thailand had 20% and South Korea had about 12%. This can be viewed as working capital of countries. It was not enough to meet the short term liabilities. It is worth mentioning that throughout the crisis, the FDI either remained constant or increased. It was only portfolio investment that dipped causing the crash of economies. The East Asian crisis is notable for many reasons, one of which is how rapidly it unfolded and how quickly things started to turn around after the crisis began. Econonmists saw signs of recovery as early as one year after the crisis began. Despite the relateivly short duration of the critical period, the crisis changed the world s understanding of how rapidly growing countries should fund and sustain their growth. Developing countries cannot rely on foreign investment and short-term debt to fund growth. The constitution of debt in East Asian countries was made up much more heavily of short term debt than long term debt, which put them in a very precarious position. Had the foreign capital flow been directed towards products, rather than portfolio management, output might have met demand and the bubble would not have formed.
Additionally, emerging nations now seek to keep foreign reserves high in comparison with total debt. This is the working capital of the country and has fostered economic debate whether this should be sufficient to sustain the needs of a country. The lessons learned and policies changed on account of the East Asia crisis help to assure that foreign investment will continue in emerging countries.