Asian Economic Crisis

Summary of Lecture
Background to the crisis y Brief Chronology of crisis y Experiences of different countries in dealing with the crisis y Lessons learnt from the crisis
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Why study the Asian Crisis?

Big impact on world economy including India y Good illustration of the interaction between the financial system and the macroeconomy y Illustrates important themes like contagion. y Had a big impact on the debate about capital account convertibility in India
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Background to the Crisis

East Asia was the fastest growing region in the decades before the crisis Strong export orientation especially compared to Latin American, India

High savings and investment Rates Good demographics Good education systems

Problems in the East Asian model

Many of the countries had high current account deficits y Fixed exchange rates encouraged borrowing in short-term foreign debt at cheap international rates. y Financial bubbles especially in the property sector y Fixed rates also meant less effective monetary policy so central banks couldnt control overheating economies y Weak financial systems with poor credit appraisal norms. y Politicized lending. Little transparency in the lending process. y Lending heavily concentrated in a few areas like property and export oriented conglomerates Eg. Top 30 chaebol had debt-equity ratios of 400% in 1996
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Current Account Deficits

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Start of Crisis
The crisis struck first in Thailand of 8% of GDP in 1996which had a current account deficit y Most of this debt was financed with short-term capital flows y Thailands debt to foreign banks rose from 29 billion dollars in 1993 to 69 billion in 1997 most of which had maturity of less than a year
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Brief Chronology
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May 14 1997. Speculative attacks on Thai baht. Thailand spends billions of dollars defending its currency July 2, 1997: Thailand baht is devalued July 11, 1997: Philippine peso is devalued August 14, 1997: Indonesian rupiah falls sharply October 20-23, 1997: Hong Kong stock market panic Oct 27, 1997: Panic spreads to Western stock markets November 17, 1997: Korean won collapses August 1998: Russia defaults on its debt. Causes turmoil in the international markets. Dow falls by 512 points in one day September 1998: Hedge fund LTCM bailed out after its collapse threatens financial system

Currencies and Stocks

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Feedback effects
Declining confidence

Financial problems for banks and companies

Plunging currencies, rising interest rates

Dealing with the Crisis

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Short run problems: Foreign exchange to pay for imports, pay off foreign debt Most countries took IMF Loans, IMF conditionalities Long-run Problems: Restoring the health of the financial sector Debt overhang: Bad debts will discourage fresh lending even when it is justified. Non-performing loans: estimates of 800 billion dollars Government needs to deal with Non Performing Loans as well as restructure the financial sector.

IMF Strategy
Focus on investor confidence and maintaining value of the currency y In favour of free capital flows y The IMF provided stabilization funds in return demanded conditionalities in the form of austerity measures like cutting fiscal deficits, raising interest rates and removing capital controls y Such policies were quite successful in South Korea and Thailand but critics claimed that they ignored political realities in countries like Indonesia and created too much suffering.
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Malaysia and Capital Controls

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A crisis creates a policy dilemma: A recession requires low interest rates and expansionary fiscal policy to boost the economy. However the economy also needs to maintain the confidence of investors and this requires high interest rates A way out of this dilemma is for a temporary capital controls which reduces capital flight. Once the economy recovers capital controls can be lifted and the strong fundamentals will hopefully prevent capital flight. (capital flight- The movement of savings and liquid financial assets from one country to another and from one currency to another. Often during financial crises, residents of the crisis country will transfer savings and other liquid assets into US dollar-denominated assets, often in the United States ) One of the most controversial policies of the crisis was Malaysias decision to raise capital controls In contrast to the IMF prescriptions: Malaysia introduced controls on capital-account transactions Lowered interest rates Reflated the domestic economy

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Other measures
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Asset management companies were created to reduce the problem of non-performing loans Encouraged the consolidation of the banking sector. A smaller number of healthier banks Opened up the financial sector to foreign banks Improved financial regulation with better disclosure and prudential norms Greater balance between different sectors. Much bigger role for consumer finance which in turn means that economic growth is more balanced between external and domestic sector.

Current account balance

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Recovery from Asian Crisis

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Lessons learned from the Asian Crisis

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Macroeconomic crises dont come out of nowhere. However financial markets can overreact Viscous feedback effects can make things worse. Importance of reserves as a buffer in cases of crisis.. This may create its own problems and may have helped cause current crisis. Potential problems with fixed exchange rates The case for globalization is weaker for capital flows than goods flows Importance of financial supervision and credit-management norms Malaysian example tentatively suggests that temporary capital controls can be justified