Question

When studying financial crises in the world, the East Asian crisis of 1997 stands out because it was so unexpected, given the sustained economic growth of these countries for a long time before the crises occurred. A. What was the East Asian crisis of 1997? Which countries were involved and what were the consequences of the crisis (on various economic indicators, such as income growth, exchange rates, etc.). B. What were the main factors that caused the financial crisis to develop? Please state at least four key factors that were associated with the crisis, providing any studies or data supporting your explanations. C. What policies would you recommend developing countries adopt to avoid future financial crises?

Answer 1

A. What was the East Asian Financial Crisis of 1997?

The East Asian Financial Crisis, also called the “Asian Contagion,” was

                A series of currency devaluations and other events that spread through many Asian markets beginning in the summer of 1997

                The currency markets first failed in Thailand as the result of the government’s decision to no longer peg the local currency to the U.S. dollar (USD).

                Currency declines spread rapidly throughout Southeast Asia, in turn causing stock market declines, reduced import revenues and government disorder.

Which countries were involved?

Eight countries involved in this crisis

1. Thailand
2. Philippines
3. Hongkong
4. Taiwan
5. Singapore
6. Indonesia
7. South Korea
8. Malaysia

Countries which are out of danger of the crisis

1. China
2. India
3. Japan
4. vietnam

What were the consequences of the crisis?

• Thailand faced the largest current account deficit. It faced at that time a budget deficit for the first time in a decade.
• The second and third largest current account deficit of the region in 1996 were found in Malaysia and Philippines respectively.
• The announcement of the baht devaluation caused other regional currencies to experience pressure.
• On July 8^th 1997, the Malaysian Central Bank defends its currency (the ringgit) which is under speculative attack.
• On July 11^th1997, after defending its currency for few days, the Philippine central bank decided to let the peso float. On the same day, the Indonesian central bank widened its intervention band for the rupiah.
• On July 14^th 1997, the Malaysian riggit was forced to float. This led Singapore to let its currency depreciate.
• On August 14^th 1997, the Indonesian rupiah was also forced to float.
• On August 20^th 1997, the IMF announced a rescue plan for Thailand, which eventually calmed down financial markets.
• On October 8^th 1997, Indonesia asks the IMF and the World Bank for financial assistance. This triggered renewal of attacks against currencies more in the north.
• On October 17^th 1997, despite being a creditor country, Taiwan was forced to let the New Taiwan dollar float.
• On October 22^nd 1997, South Korea nationalized Kia Motors, which led Sandard and Poor to downgrade the South Korean foreign debt.
• On the same day, the Hong Kong Central Bank raised interest rates to defend its currency. The stock market crashed by 10% that day and by 25% after three days.
• For the first time, European and US financial markets feel the tornado. On October 27^th the Dow Jones fell by 7% (mini crash)
• On November 17^th 1997, the South Korean won was forced to float.
• On November 21^st 1997, South Korea requested IMF aid
• On December 4^th 1997, after Thailand and Indonesia, South Korea obtained a $57 billion aid package and signed agreement with big foreign banks, avoided defaulting on its $100 billion short term debt.
• The crisis really short lived but it was severe.

What were the main factors for the crisis to develop?

1. The high growth rates and sound macroeconomic results of East Asian Countries attracted a lot of short term and long term capital from foreign countries, especially from developed countries. These capital inflows gave rise both to large current account deficits and inflows of foreign currency reserves.
2. These capital inflows created real estate and asset bubbles. When some of these bubbles started to burst in 1995-1996, investors started to change their portfolio positions, hence, reducing short term capital inflows to these countries.
3. The resulting downward pressure on their currencies sparked off a flight to quality to Western financial markets. Short term capital inflows suddenly dried off leading to a currency crisis in these economies. This currency crisis led to banking crisis.
4. In emerging and developing countries, investment finance generally depends heavily on bank loans. Despite structural problems in the banking sector in these countries, there were two specific characteristics of the banking sector which made things worse:
   1. Maturity mismatch: the traditional maturity mismatch of the banking sector(borrowing short and lending long) was particularly acute in these countries as banks used a lot of short term interbank liquidity.
   2. Currency mismatch: Bank borrowed in foreign currencies (dollars) taking advantage of cheap foreign capital inflows, and let to domestic borrowers in domestic currency.
5. When investors’ mood reversed, maturity mismatch worsened creating a liquidity crisis for the banking sector.
6. The flight to quality caused the depreciation of East-Asian currencies leading to a much higher value (in domestic currency) of dollar denominated debts of the banking sector. This created a solvency crisis for the banking sector.
7. These two problems led to a turmoil in the banking sector calling for a rescue from the governments and the IMF.
8. The deterioration of the banking sector’s balance sheet further deepened the currency crisis, spreading the panic of the Asian Financial Market.
9. Credit crunch plus sudden change in the consumers’ and investors’ mood led to a short lived but very strong recession.
10. However capital outflows, fiscal and monetary policy helped a lot in containing the crisis by turning the current accounts into surpluses and hence, by stabilizing currencies.