EAST ASIAN FINANCIAL CRISIS OF 1997

HAKAN YILMAZKUDAY

The crisis that took place in the late 1990s in Asia rekindled interest in financial crisis.
The role of the financial sector and is observed to be the main reason for Asian financial
crisis. Since currency crisis and financial crisis are closely related in the sense of
causality, one should take into account the relation between them when analyzing Asian
crisis. Instead of sticking with only one explanation for the link between financial and
currency crises, Kaminsky and Reinhart (1999) classify the models of this link in three
groups.

One chain of causation runs from balance of payments problems to financial crisis. An
external shock, such as an increase in foreign interest rates, coupled with a commitment
to a fixed parity, will result in the loss of reserves, because agents will find it more
profitable to invest in foreign countries. Within this group, Goldfajn and Valdes (1997)
explain the link between the those crises as follows. Deposits at domestic banks are part
of the domestic liabilities that investors will attempt to convert into reserves in a currency
crisis. If not sterilized, this will lead to a credit crunch, increased bankruptcies and
financial crisis. Thus, a run on the currency is typically associated with a run on the
financial system.

The second group models point to the opposite causal direction: financial sector problems
give rise to the currency collapse. Such models stress that when central banks finance the
bailout of troubled financial institutions by printing money, a currency crash prompted by
excessive money creation will occur. Saxena and Wong (1999), and Burnside,
Eichenbaum and Rebelo (2001; BER henceforth) are in this second group saying that, in
Asia, a crisis in the financial sector led to a currency crisis. In the BER model, the
government undertakes the possible costs of the banking system by insuring the deposits
at commercial banks. If it is certain that the banking sector will experience a crisis, then

1
the private agents will expect that the government will run a huge budget deficit because
it will undertake the possible costs of the banking system. If the government does not
want to increase the tax rates or reduce its expenditure, there are two ways left to finance
the budget deficit: to decrease the level of real domestic debt by inflation (devaluation) or
seigniorage. Furthermore, under fixed exchange rate, with the assumption of perfect
foresight, the agents will realize that the government will abandon the fixed exchange
rate regime, and thus the speculators will carry out a speculative attack which will lead to
a capital outflow. This, in turn, will lead to a balance of payments deficit, and thus, we
will end up with the first group models and their undesired problems.

The contribution of the BER model is that it lets the probability of a crisis when there are
appropriate economic fundamentals. If the crisis takes place just after the realization that
the banking sector will have a crisis, then there will be neither a huge budget deficit, nor
an increase in money supply just before the crisis. That is to say, the model explains the
crisis in countries in which the economic indicators (fundamentals) are appropriate,
which is the case in Asian crisis.

The third group models contend that currency and financial crises have common causes.
According to these models, exchange rate based stabilization programs have well-defined
dynamics: Because inflation converges to international levels only gradually, there is a
marked cumulative real exchange rate appreciation. Also, at the early stages of the plan,
there is a boom in imports and economic activity, financed by borrowing abroad. As the
current account deficit continues to widen, financial markets become convinced that the
stabilization program is unsustainable, fueling an attack against the domestic currency.
Since the boom is usually financed by a surge in bank credit, as banks borrow abroad,
when the capital inflows become outflows and assets markets crash, the financial system
caves in.

2
Belonging to the third group models, Radelet and Sachs (1998) claim that the distinction
between short-term and long-term capital movements is important here. While short-term
capital flows are used mainly to finance trade flows, the long-term capital flows,
especially foreign direct investment and equity portfolio flows, are to finance longer term
investments that lead to growth. One has to take this distinction into account while
analyzing the crisis. In the third group models, it is also modeled how financial
liberalization together with microeconomic distortions such as implicit deposit insurance
can make boom-bust cycles even more pronounced by fueling the lending boom that
leads to the eventual collapse of the financial system.

After focusing on the possible causes of the Asian crisis, following Radelet and Sachs
(1998), we can now turn our attention to preventing and managing future crisis. Since
short-term capital flows are for trade flows, and long-term capital flows are for economic
growth, the policy goal should be to support long-term capital flows, especially foreign
direct investment, and equity portfolio flows, but to limit short-term international flows
mainly to the financing of short-term transactions. Moreover, better banking supervision
will solve the problem of unstable capital markets. Banks and non-financial corporations
could be discouraged from short-term international financing, for example with
maturities of less than six months, except to finance documented trade transactions. As
always, one can approach such limits via taxation (as in Chile, which imposes a 30
percent reserve requirement on dollar deposits in the banking system), or via outright
supervisory limits. In sum, one has to take into account the distinction between long-term
and short-term capital flows when analyzing financial crisis in open economies.

3
References:

• Burnside, C., Eichenbaum, M., and Rebelo, S. (2001), “Prospective Deficits and the
Asian Currency Crisis,” Journal of Political Economy, 109(6): 1155-1197 .

• Goldfajn, I. and Valdes, R. (1997), “Capital Flows and the Twin Crises: the Role of
Liquidity,” International Monetary Fund Working Paper, No. 97/87.

• Kaminsky, G. and Reinhart, C.M. (1999), “The Twin Crises: The Causes of Banking
and Balance of Payment Problems,” American Economic Review, 89(3): 473-500.

• Radelet, Steven and Jeffrey Sachs. 1998. “The East Asian Financial Crisis: Diagnosis,
Remedies, Prospects.” Brookings Papers on Economic Activity, 1998:1, pp. 1-74.

• Saxena, S.C., and Wong, K., (1999), “Currency Crises and Capital Controls: A
Selective Survey”, University of Washington, mimeo.