What caused the financial crisis in Asia?

The Asian financial crisis, often known as the “Asian Contagion,” was a series of events that started in July 1997 and extended throughout Asia, including currency devaluations and other things. The crisis began in Thailand when the government withdrew the de facto peg of the local currency to the U.S. dollar after exhausting a large portion of the nation’s foreign exchange reserves to protect it from months of speculative pressure.

Just a few weeks after Thailand ceased protecting its currency, pressure from the speculative market forced Malaysia, the Philippines, and Indonesia to do the same. By October, the crisis had moved to South Korea, where the government was on the verge of default due to a balance-of-payments problem.

There was also pressure on other economies, but those with strong economic fundamentals and sizable foreign exchange reserves fared far better. Hong Kong’s currency, tied to the U.S. dollar via a currency board system and supported by sizable U.S. dollar reserves, has withstood several significant but failed speculative attacks.

The Asian Financial Crisis’s effects

Other Asian currencies decreased alongside the Thai baht, some of them quickly. Capital inflows slowed or even stopped throughout Asia. Before the financial crisis, the Thai baht traded around 26 to the U.S. dollar. However, by the end of 1997, it had lost half its value and was only worth 53 to the dollar by January 1998. By the end of 1997, the South Korean won had dropped from around 900 to 1,695.

The Indonesian rupiah fell to 14,900 in June 1998 from roughly 2,400 in June 1997, less than one-sixth of its pre-crisis value. Some of the more severely impacted nations experienced a severe recession. The growth of Indonesia’s GDP decreased from 4.7% in 1997 to -13.1% in 1998. In the Philippines, it decreased from 5.2% to -0.5%. Similar declines in GDP growth were seen in Malaysia (7.3% in 1997 to -7.4% in 1998) and South Korea (6.2% to -5.1%).

The subsequent economic catastrophe in Indonesia caused the President Suharto regime, which had been in place for three decades, to fall. The International Monetary Fund (IMF) and the World Bank, among others, intervened to ease the crisis by injecting over $118 billion into Thailand, Indonesia, and South Korea to support their economies.

Affected nations reorganized their economies due to the crisis, typically because the IMF imposed change as a condition of assistance. Each country’s precise policy adjustments were varied, but they usually required bolstering fragile financial institutions, reducing debt, boosting interest rates to stabilize currencies, and reducing government expenditure.

The crisis is also a useful case study for economists to comprehend how interconnected markets impact one another, particularly currency trading and managing national accounts.

The Asian Financial Crisis’s fundamental causes

The industrial, financial, and monetary government policies and the investment trends they generated all had a role in the crisis. Markets responded violently as the crisis started, and one currency after another came under pressure. Current account deficits, high levels of foreign debt, rising budget deficits, excessive bank lending, subpar debt-service ratios, and unbalanced capital inflows and outflows were a few macroeconomic issues.

In the years before the crisis, efforts to support export-led economic development were the cause of many of these issues. Governments collaborated extensively with industry to encourage exports, offering subsidies to favored companies, more favorable financing, and currency pegs to the dollar to guarantee an exporter-friendly exchange rate.

While encouraging exports, this also increased risk. Investors frequently did not evaluate the profitability of an investment but instead turned to its political support because of explicit and implicit government promises to save local businesses and institutions. Investment policies also facilitated tight alliances between regional conglomerates, financial institutions, and industry regulators. Large amounts of foreign currency poured in, sometimes with little regard for consequences. These elements all combined to create a significant moral hazard in Asian economies, which promoted significant investment in questionable and possibly risky initiatives.

The strong economic growth rates in many nations were hiding significant weaknesses as the crisis expanded, and it became obvious. In particular, domestic credit had been growing quickly for years, sometimes unchecked, leading to considerable leverage and loans given to questionable ventures.

Along with increasing current account deficits and an increase in external debt, the situation was exacerbated by quickly rising real estate values, which were frequently propelled by easy access to credit. Heavy foreign borrowing, sometimes at short maturities, exposed banks and enterprises to enormous financing and exchange rate concerns, which long-standing currency pegs had previously hidden. When the pegs broke down, businesses with debts in foreign currencies found far larger debts in local currencies, driving many of them into insolvency.

Current account deficits have also crept into several Asian nations. A nation is effectively a net lender to the rest of the world if its current account is in excess. The nation is a net borrower from the rest of the globe if the current account balance is negative. Due to significant government expenditure (mostly aimed at sustaining ongoing export growth), current account imbalances have widened.

Addressing the Asian Financial Crisis

By providing loans to stabilize the impacted economies, the IMF stepped in to stop the crisis. Thailand, Indonesia, and South Korea received short-term loans totaling about $118 billion from the IMF and other parties.

However, the bailouts included requirements: governments had to increase taxes, reduce expenditures, and discontinue several benefits. Many of the impacted nations started to show indications of recovery by 1999.

Additionally, other financial institutions stepped in. For instance, the U.S. Federal Reserve Bank facilitated an agreement in December 1997 wherein U.S. banks owed money to South Korean businesses on short-term loans and voluntarily agreed to roll those debts into medium-term loans.

The Asian Financial Crisis’s lessons

Numerous lessons learned during the Asian financial crisis are still applicable today. First, watch out for asset bubbles since they tend to pop. Another is the requirement for wise economic development strategies and government expenditure restraint.

What impact do monetary policy and government expenditure have on the value of a currency?
Consumers have more money to spend when governments enact laws that keep taxes low, subsidize the cost of basic commodities, or employ other strategies that effectively put more money in people’s pockets. Since many products and services in most countries are at least partially imported, this rise in spending generates demand for foreign currency, often U.S. dollars, since importers must sell local currency and buy foreign currency to pay for imports.

When the same policies encourage significant investment in infrastructure, new firms, and other economic initiatives, demand for foreign currency (and the sale of local currency to purchase it) surges enormously. If there isn’t a desire to acquire it, such as when exporters sell the foreign currency they get from exports, the value of local currency declines as more is available for sale on foreign exchange markets.

Why do governments maintain high exchange rates?

Governments, particularly those of emerging countries, attempt to manipulate exchange rates to balance their capacity to pay debts denominated in foreign currencies. Governments in emerging economies frequently raise money by issuing bonds denominated in U.S. dollars, Japanese yen, or euros because investors prefer assets issued in more stable currencies.

However, suppose the domestic currency’s value declines relative to the currency in which its debt is expressed. In that case, the debt is increased since more local currency is required to pay it off. Therefore, local borrowers needed twice as many baht to cover loans denominated in U.S. dollars when the Thai baht lost half of its value in 1997. A stronger local currency also makes imports less expensive in local currency because many emerging nations also rely on imports.

Why do governments maintain depressed exchange rates?

In contrast, governments can work to maintain low exchange rates to make exports more competitive.

After years of protests from American businesses about competition from cheap Japanese goods, the United States government persuaded Japan to allow its currency to be appreciated as part of the Plaza Accord in the 1980s. The currency’s value increased from 250 yen to one dollar at the beginning of 1985 to less than 130 yen in 1990. The trade imbalance between the United States and Japan decreased from $55 billion in 1986 to $41 billion in 1990.

When markets started to put downward pressure on Asian currencies in 1997, decades of economic policy planning that involved strong links among government policy planners, regulators, the sectors they governed, and financial institutions came to a head. The nations with the highest levels of debt and the least available financing were the most vulnerable.

The IMF intervened to save the most distressed economies, but in return, it placed stringent requirements. Governments had to reduce expenditures, increase taxes, abolish subsidies, and reorganize their financial systems, among other things.

Conclusion

• After months of market pressure to devalue its currency, Thailand ceased defending the baht in July 1997, sparking the beginning of the Asian financial crisis.
• The epidemic led to significant and widespread currency losses, some particularly severe.
• The economic development strategies that sparked the crisis promoted investment and generated substantial debt (and risk) to finance it.
• The International Monetary Fund (IMF) placed severe expenditure limitations on several nations in return for its assistance.
  Since then, the affected nations have put safeguards in place to prevent the problem’s recurrence.