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Asian financial crisis (1997-2002)

The East Asian economic crisis is probably the most important economic event in the

region of the past few decades. The earlier optimistic expectation was that it would last onlysome months. Instead the financial crisis transformed into a full-blown recession ordepression, with forecasts of GNP growth and unemployment becoming gloomier foraffected countries.

The causes of the debacle are many and disputed. One of the causes stated saysThailand'seconomy developed into a bubble fuelled by "hot money". The same bubble spread toMalaysia, and Indonesia. These economies in particular had maintained high interest ratesattractive to foreign investors looking for a high rate of return. As a result the region'seconomies received a large inflow of money and experienced a dramatic run-up in assetprices. By number, a total of US$184 billion entered developing Asian countries as net

private capital flows in 1994-96, according to the Bank of International Settlements. In 1996,US$94 billion entered and in the first half of 1997 $70 billion poured in.

At that point of time, Thailands currency baht was initially pegged at 25 to the US dollar. In1997, the baht was hit by massive speculative attacks. The government failed to defend thebaht, which was pegged to the basket of currencies in which the U.S. dollar was the maincomponent, against international speculators. Thailand's booming economy came to a haltamid massive layoffs in finance, real estate, and construction that resulted in huge numbers ofworkers returning to their villages in the countryside and 600,000 foreign workers being sentback to their home countries. The baht devalued swiftly and lost more than half of its value.The baht reached its lowest point of 56 units to the US dollar in January 1998. The Thai stock

market dropped 75%. The Thai government was eventually forced to float the Baht, on 2 July1997.

What happened in East Asia is not peculiar, but had already happened to many LatinAmerican countries in the 1980s, to Mexico in 1994, to Sweden and Norway in the early1990s. They faced sudden currency depreciations due to speculative attacks or large outflowsof funds. In the case of East Asia, although there were grounds to believe that some of thecurrencies were over-valued, there was an over- reaction of the market, and consequently an"over-shooting" downwards of these currencies beyond what was justifiable by fundamentals.It was a case of self-fulfilling prophecy. It is believed that financial speculators, led by somehedge funds, were responsible for the original "trigger action" in Thailand. The Thai

government used up over US$20 billion of foreign reserves to ward off speculative attacks.Speculators are believed to have borrowed and sold Thai baht, receiving US dollars inexchange. When the baht fell, they needed much less dollars to repay the baht loans, thusmaking large profits.

The sequence of events leading to and worsening the crisis included the following.

(a) Financial liberalisation

Firstly, the countries concerned carried out a process of financial liberalisation, where foreign

exchange was made convertible with local currency not only for trade and direct-investmentpurposes but also for autonomous capital inflows and outflows (i.e. for "capital account"

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transactions); and where inflows and outflows of funds were largely deregulated andpermitted. This facilitated the large inflows of funds in the form of international bank loans tolocal banks and companies, purchase of bonds, and portfolio investment in the local stockmarkets. in order to meet the requirements for entering the OECD. Its banks and firmsreceived large inflows of foreign loans, and the country accumulated US$150 billion of

foreign debts, most of it private-sector and short-term. In Indonesia, local banks andcompanies also borrowed heavily from abroad.

(b) Currency depreciation and debt crisis

The build-up of short-term debts was becoming alarming. What transformed this into crisisfor Thailand, Indonesia and South Korea was the sharp and sudden depreciation of theircurrencies, coupled with the reduction of their foreign reserves in anti- speculation attempts.When the currencies depreciated, the burden of debt servicing rose correspondingly in termsof the local- currency amount required for loan repayment. That much of the loans wereshort-term was an additional problem.

As a result of these controls, Malaysia's external debt has been kept to manageable levels.Nevertheless the debt servicing burden in terms of local currency has been made heavier bythe sharp ringgit depreciation.

(c) Local Asset Boom and Bust, and Liquidity Squeeze

The large inflows of foreign funds, either as loans to the banking system and companiesdirectly, or as equity investment in the stock markets, contributed to an asset price boom inproperty and stock markets in East Asian countries.

With the depreciation of currencies and expectations of a debt crisis, economic slowdown orfurther depreciation, substantial foreign funds left suddenly as withdrawal of loans andselling off of shares. Share prices fell. Thus the falls in currency and share values fed eachother. With weakened demand and increasing over-supply of buildings and housing, theprices of real estate also fell significantly.

For the countries afflicted with sharp currency depreciations and share market declines, theproblems involved:** The much heavier debt servicing burden of local banks, companies and governments thathad taken loans in foreign currencies,

** The fall in the value of shares pledged as collateral for loans by companies andindividuals, and the fall in the values of land, buildings and other real estate property. Thishas led to financial difficulties for the borrowers.** The higher interest rates caused by liquidity squeeze and tight monetary policies havecaused added financial burdens on all firms as well as on consumers that borrowed;** As companies and individuals face difficulties in servicing their loans, this has increasedthe extent of non-performing loans and weakened the financial position of banks, and** Higher inflation caused by rising import prices resulting from currency depreciation.

Finally, the International Monetary Fund (IMF) stepped in to initiate a $40 billion program tostabilize the currencies of South Korea, Thailand, and Indonesia, economies particularly hard

hit by the crisis.