The causes of the Asian currency and financial crisis

What caused the Asian currency and financial crisis?

Abstract

The paper explores the view that the Asian currency and financial crises in nineteen ninety-seven and nineteen ninety-eight reflected structural and policy distortions in the countries of the region, even if market overreaction and herding caused the plunge of exchange rates, asset prices and economic activity to be more severe than warranted by the initial weak economic conditions. The first part of the paper provides an overview of economic fundamentals in Asia on the eve of the crisis, with emphasis on current account imbalances, quantity and quality of financial 'overlending', banking problems, and composition, maturity and size of capital inflows. The second part of the paper presents a reconstruction of the Asian crisis - from the antecedents in nineteen ninety-five to nineteen ninety-six to the recent developments in early nineteen ninety-nine - in parallel with a survey of the debate on the strategies to recover from the crisis, the role of international intervention, and the costs and benefits of capital controls.

Four Introduction

What were the causes of the Asian economic, currency and financial crises of nineteen ninety-seven to nineteen ninety-eight? Two main hypotheses and interpretations have emerged in the aftermath of the crisis. According to one view, sudden shifts in market expectations and confidence were the key sources of the initial financial turmoil, its propagation over time and regional contagion. While the macroeconomic performance of some countries had worsened in the mid nineteen nineties, the extent and depth of the nineteen ninety-seven to nineteen ninety-eight crisis should not be attributed to a deterioration in fundamentals, but rather to panic on the part of domestic and international investors, somewhat reinforced by the faulty policy response of the International Monetary Fund and the international financial community.

According to the other view - advanced in this paper - the crisis reflected structural and policy distortions in the countries of the region. Fundamental imbalances triggered the currency and financial crisis in nineteen ninety-seven, even if, once the crisis started, market overreaction and herding caused the plunge of exchange rates, asset prices and economic activity to be more severe than warranted by the initial weak economic conditions. A synthetic overview of our interpretation is provided in section two, while sections three to five present a systematic assessment of the sources of economic tension at the root of the Asian crisis. This is based on the analysis of the available empirical evidence for the following countries: South Korea, Indonesia, Malaysia, Philippines, Thailand, Singapore, Hong Kong, China and Taiwan. Macroeconomic imbalances in these countries are assessed within a broad overview of structural factors: current account deficits and foreign indebtedness, growth and inflation rates, savings and investment ratios, budget deficits, real exchange rates, foreign reserves, corporate sector investment, measures of debt and profitability, indexes of excessive bank lending, indicators of credit growth and financial fragility, monetary stances, debt-service ratios, dynamics and composition of capital inflows and outflows, and political instability.

The rest of the paper is structured as follows. Section six presents a reconstruction of the Asian meltdown, from the period leading to the crisis to its eruption in nineteen ninety-seven, and discusses policy responses, contagion effects, and the role of Japan. In section seven we provide an overview of the debate on policy strategies to recover from the crisis, with particular emphasis on the role played by the International Monetary Fund. Section eight singles out the key points in the current debate about the reform of the international financial system and the desirability of free capital mobility. Section nine focuses on the most recent evolution of the Asian meltdown into a global turmoil in the summer of nineteen ninety-eight and the recovery of early nineteen ninety-nine.