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Economic Development in AsiaChapter 3 The Asian Crisis and Recent

Developments

June 1997, after a sustained attackon the currency led by currencyhedge funds, the Thai bahtsustained a large devaluation.

Currency devaluations in Malaysia,Indonesia and the Philippinesfollowed in July.

The currency weakness extendedto Australia, Hong Kong and Koreacurrencies in October.

S tart of the Asian Crisis

The Asian Crisis

By early 1998, currencies fell by 35% to 55% forKorea, Philippines, Malaysia and Thailand, andmore than 15% for Singapore and Taiwan.

Indonesia suffered greatest fall of 80%.

Equity prices also fell as a result of investoruncertainty and currency volatility (Table 3.1).

The Asian Crisis

Thin and restricted equity markets exaggerated thedecline.

Lack of hedging facilities forced investors to reduceholdings dramatically.

Interest rates were raised to help stabilize currencies andliquidity was reduced.

The result was a sharp decline in aggregate economicactivity in late 1997 and in 1998.


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Explanations for the AsianCrisis

There are three broad

explanations, none of them alonecompletely satisfactory.

First, a speculative bubble in thehousing and equity markets arosewhich was funded and sustainedby excessive lending by thebanking system.

Explanations for the AsianCrisis

Second, external sector difficulties emerged

including slow export growth, loss of externalcompetitiveness and rapid growth in currentaccount deficits.

Third, capital flight and investor panic spreadacross the region through a contagionmechanism as a result of globalization.

The Asian Crisis The Bubble Economy (1)

First, the bubble economy was the result of interactionbetween lenders (mostly banks) that borrowed offshoreat high interest rates and relend at higher rates todomestic investors.

The domestic investors borrowed extensively to financespeculative investments in the housing and equity

markets.


This created a speculative bubble thatdepended on a stable exchange rateand high profits.

High profits became more improbableas the boom reached its peak, whichwas further undermined by thesuccessive devaluations in all theeconomies as the crisis unfolded.

Banking weakness was reinforced bya lack of competition and unsoundlending practices.

The Asian Crisis The Bubble Economy (1) These included risky long term lending in local currency

using short term dollar loans from overseas lenders.

When these borrowers defaulted it resulted in theinability of the banks to repay these short term dollarobligations.

This banking crisis was also influenced by moral hazard


Moral hazard occurs when an agent takes more riskbecause they are insured against the negativeconsequence of such actions.

In the case of the Asian financial crisis banks thoughtsthat governments would insure a stable exchange rate.

They also might have thought that the government wouldbail them out if they found themselves in financial trouble


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The Asian Crisis External S ector Difficulties (2)

Second , as the bubble of the early 1990s progressed,current account deficits also grew as offshoreborrowing increased.

While exports were growing rapidly, this was viewed as asign of strong investment and growth enhancing capitalexpansion.

The Asian Crisis E xternal Sector D ifficulties (2) However, when export growth

began to sag in 1996 thislarge current account deficitsbecame a growing liabilityand worry for internationalinvestors.

Exchange rates were tied tothe dollar and exports werehurt in international marketsas the dollar appreciated inthe mid 1990s.

The Asian Crisis Contagion Effects (3)

Third , there was a strong contagion effect as thefinancial crisis spread across the region.

Countries that had strong currencies and economies,such as Hong Kong, Singapore and Taiwan were alsoadversely affected.


As the foreign exchange crisis unfolded, there was adramatic turn around in net private capital flows to theregion from a $97 billion inflow in 1996 to a $12 billionoutflow in 1997.

This $109 billion reversal was about 10% of the GDP ofthe five most affected economies Indonesia, Korea,Malaysia, Philippines, and Thailand.


There was also a dramaticreversal in bank credit whichalso amounted to about 10percent of GDP.

Together, the reversal of capitalflows and bank credit created aliquidity crisis that led to asharp fall in income and output.


Indonesia, which had been a model of probity andsensible policies was hardest hit by the crisis as itsexchange rate fell by over 50 percent and aggregateincomes fell dramatically.

This contagion effect was the result of investors pullingout of many economies simultaneously .


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The pressure that arose on all the currencies of theregion could have been a combination of this contagioneffect as well as a process of competitivedevaluations as investment funds left the region.

The Asian Crisis Contagion Effects (3) P ost -C risis Experience

The impact of the crisis was fully felt in 1998 when all thecrisis countries and most other countries had negative orvery small rates of positive growth.

PRC and Taiwan were the only exceptions.

Equity prices also fell across the region in 1998.

P ost -C risis Experience

Beginning in 1999, there has been a recovery in growthand equity markets.

This recovery has been accompanied by a significantamount of industrial and financial restructuring.

Many countries suffered from a high level of Non -Performing Loans (NPLs).


To deal with these NPLs, the most affected countriescreated separate agencies to deal with them. TheseAsset Management Companies (AMCs) have takenmany of the bad loans and negotiated their liquidation.

Korea and Malaysia have been particularly successful inreducing NPLs, enabling the banking system to begin toextend new loans.


Thailand and Indonesia have been only moderatelysuccessful while in the Philippines, the level of NPLs,though small during the crisis, has crept up in recentyears.


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S ocial Impact of the Crisis

The fall in output and employment created hardshipsfor many segments of the society in the affectedcountries.

There was significant reverse migration to rural fromurban areas as job opportunities dried up.

Poverty levels increased between 1997 and 1998.

S ocial Impact of the Crisis

Disadvantaged groups

such as the poor,women, children andthe elderly were theworse hit by the crisis.

Some adverse affectson school enrollmentand on healthindicators wereobserved.

The Recovery Part 1 The Recovery Part 2

Between 2002 and 2007 economic growth in the Asianregion accelerated, led by India and China. Livingstandards increased and poverty fell.

Domestic demand and foreign trade were both importantfactors in the resumption of growth.

As the recover progressed financial restructuring

proceeded and the financial systems strengthened.

The Recovery Part 2

2005 2006 2007Thailand 4.5 5.1 4.8Malaysia 5.3 5.8 6.3Indonesia 5.7 5.5 6.3Philippines 5.0 5.4 7.2Hong Kong 7.1 7.0 6.4Singapore 7.3 8.2 7.7Korea 4.2 5.1 5.0Taiwan 4.2 4.9 5.7China 10.4 11.7 11.9

The Recovery Part 2

The region has grown much richer in the decade sincethe Asian crisis.

China has emerged as a regional economicpowerhouse.

Half the GDP of the region and one third of exportsoriginates in China

China is now the largest trader in Asia overtaking Japan.


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The Recovery Part 2

China joined WTO several years ago.

Import GDP ratio is 34% in China versus 9% for Japan.

Shows Japan is still somewhat protectionist.

Middle income countries are being squeezed by China.

In Southeast Asia in particular.

The Recovery Part 2

China competes in many different international marketsfrom labor intensive to skill intensive.

Innovation and new products are drivers of trade in Asianow.

60% of export growth in Asia is in new varieties andproducts not more of the same products.

Geography and outsourcing are important and locationaladvantages are shaped by various factors.

The Recovery Part 2

History, availability of manpower, availability of capital,cost of shipping and agglomeration economies all play arole.

Shenzen in China and Bangalore in India are examplesof agglomeration economies.

Export processing zones help create incentives for high

growth export development and innovation.

Recovery Part 3 As the global economic crisis unfolds in 2009 Asia is

being adversely affected.

Slower growth in Asia in 2009 and perhaps 2010 isanticipated.

There will be a slowdown in export demand fromEurope, Japan and the United States .

Asia is in good shape to offset these anticipatedweaknesses in the foreign sector with monetary andfiscal stimulus.

Recovery Part 3 Most countries cut interest rates in last four months of 2008.

Falling energy and food prices should ameliorate anytendencies toward inflation.

There has been general fiscal stimulus.

Chinas projected $850 billion additional spending oninfrastructure in next few years.

East Asia and Southeast Asia have current account surpluses.

Recovery Part 3

All countries in the region have ample foreign exchangereserves.

India could have a more difficult time than the rest of theregion.

It has a large fiscal deficit which limits f iscal stimulus.

Lack of willingness of overseas lenders to investment.


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Recovery Part 3

As the global recession deepens greater cuts in employmentand exports in Asia.

Could create greater social tension.

Exacerbate poverty with reverse migration.

Singapore, Hong Kong and Malaysia most exposed to foreigntrade.

Both Hong Kong and Singapore adversely affected in Asiancrisis of 1997.

Recovery Part 3

Thailands prospects will also be adversely affected by politicaluncertainty.

Taiwan will have to fight its way through a recession that has alreadybegun.

Korea has a lot of household debt which could slow the economyfurther.

But a big fiscal stimulus and currency depreciation of around 30percent in 2008 which should boost exports.

Recovery Part 3

Volatility in many markets will restrain risk taking andinvestment.

Volatility causes sharp changes in balance of payments

Puts pressure on governments to adjust their budgets toreflect these shifts.

It creates uncertainty in the business community

Has a dampening impact on investment.

Recovery Part 3

The economic recovery continued into the second andthird quarter of 2009.

Industrial countries and developing countries in Asia allbenefited.

Stimulus packages were adopted by many countriesincluding fiscal and monetary measures.

Recovery Part 3

Country Fiscal stimulus 2009/2010as a percent of GDP

China 4.8

India 0.5

Indonesia 2.5

Korea 2.7

Malaysia 5,5

Philippines 4.1

Agenda for Reform

In the wake of the Asian crisis,there were a number of reforms

Continuation of the debtrestructuring process with help of

AMCs.

Arrangements of credit lines withthe private sector.

Reform of exchange rate regimesto reduce the chance of abruptcurrency devaluation.


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The movement of hot money that takes advantage oflarge short term interest differentials was discouraged ormade illegal.

Consideration of capital account reforms to includepossible taxes on short term capital but where notapproved.

Possible controls on international portfolio movementswere also considered but not implemented.

Agenda for Reform Agenda for Reform

Minimum international standardsof financial practice wereimplemented.

Accountability and transparencyof business practicesstrengthened.

Increased internationalsurveillance to detect possiblefuture financial crises have beenconsidered but notimplemented.

Agenda for Reform

Basle accords used to strengthen supervision andregulation of banking systems.

Introduce greater competition in financial markets whilestrengthening prudential regulations.

Improve accounting and disclosure standards.

Agenda for Reform

Introduce greater flexibility and depth into financialmarkets including greater hedging and providing greateraccess for foreign investors.

Maintain open trading environments in keeping withWTO and regional trading arrangements.

Agenda for Reform

Look into ways of restraining FDI concessions thatdistort incentives and distort the flow of investment.

Enhance the flow of technical expertise, innovation andhuman capital flows and exchanges.

Continue to undertake research into the process offinancial and economic crises.

Growth projections

In this section we explore prospect for future growth andstructural change.

We begin with a simple growth model

y = (ls) h + (1 - ls) k + a

where y is growth income h i s the rate of change in educationadjusted labor input, k is the rate of growth in capital, ls islabors share in income, (1 - ls ) is capitals share in incomeand a is total factor productiv ity.


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Growth projections

If we assume that the capital to output ratio is fixed in theshort run then we can substitute y for k on the right handside of this equation and rearrange

y = h + a/ ls

income growth (y) is a function of the growth of thelabor force adjusted for improved quality by highereducation and better health (h), the share of labor in totalincome (ls) and TFP (a).

Growth projections

The rest of the section looks at various assumptionsabout these factors and projects growth into the future.

The main conclusion is that estimates for TFP (a) inSouth Asia using the past tend to underestimate the rateof growth.

We have also oversimplified because we havent lookedat saving potential.

You can read about this on pages 46 and 47.

Growth projections By considering the factors in these simple growth models

we can get some insights into what causes rapid growth.

Investment

TFP (a)

Labor force growth (ls)

Education and health (h)

Governance, corruption, foreign investment alsoimportant as indirect determinants of TFP

S ummary

Causes of the Asian financial crisis.

Analysis of the impact and severity of the financial crisisin affected countries.

Policy implications gained.

S upplementary Resources The Asian Crisis Four Years On by IMF The Asian Crisis: Cause & Cures by IMF

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