Asian Financial Crisis

Time occurred 

July 1997 – December 1998

Overview

The Asian Financial Crisis, also known as the Asian Contagion, was a period of financial turmoil that gripped much of East and Southeast Asia beginning in July 1997. The crisis started in Thailand before spreading to neighbouring economies, raising fears of a destabilised worldwide economy.

Originating in Thailand, it followed the financial collapse of the Thai baht, which was heavily affected by the decision to devaluate the Thai baht from the U.S. dollar after depleting much of the country’s foreign exchange reserves. The move led to a sharp devaluation of the Thai currency and massive capital outflows of the nation.

What caused the Asian financial crisis

Excessive Foreign Borrowing

In the late 1980s and early 1990s, many economies of the Asian region experienced high growth of 8%- 12% GDP with a maintained high rate of returns to attract foreign investors. Attractable interest rates plus the deregulation of financial markets led to a massive influx of capital into the Asian economies.

However, these countries did not have the appropriate regulatory framework to keep up with the pace of economic growth. To finance the rapid growth, those countries borrowed large amounts of short-term foreign debt, primarily in US dollars. When the local currencies depreciated, the debt burden became difficult to repay.

Fixed Exchange Rate Regimes

As the result of policies to promote export-led economic growth, governments of the Asian countries worked closely with manufacturers to support exports, including providing subsidies to favoured businesses, more favourable financing, and a currency peg to the U.S. dollar to ensure an exchange rate favourable to exporters.

Many Southeast nations maintained fixed or semi-fixed exchange rates to the U.S. dollar to achieve stability. On the other hand, the increase in the U.S. dollar led to overvalued currencies and caused their own exports to become more expensive and less competitive in the global markets.

Excessive risk-taking behaviour

Government support, both explicitly and implicitly, to bail out the domestic industries and banks if they faced financial troubles contributed to a massive moral hazard in Asian economies. That meant investors merely evaluated the investment’s profitability and underlying risks but rather focused on the political backing of the company or project.

Banks were lending extensively, often to politically connected conglomerates, without properly assessing the risks of those investments. Many loans went to speculative projects (like real estate developments) that were marginally profitable or even unsound.

Consequences

Currency devaluation

Just weeks after Thailand stopped defending its currency, Malaysia, the Philippines, and Indonesia were also compelled to let their currencies fall as speculative market pressure built. By the end of 1997, currencies of the affected countries, including the Thai baht, Indonesian rupiah, South Korean won, and Malaysian ringgit, experienced dramatic devaluations. At the peak of the crisis, the value of the Indonesian rupiah was down by 80 per cent, the Thai baht by more than 50 per cent, the South Korean won by nearly 50 per cent, and the Malaysian ringgit by 45 per cent.

Collectively, capital inflows of these mostly affected economies dropped by more than $100 billion in the first year of the crisis.

Economic contraction

Across Asia, many heavily affected economies fell into severe recessions. Indonesia’s GDP contracted by over 13% in 1998. In the Philippines, it slid from 5.2% to -0.5% over the same period. Malaysia’s GDP growth similarly slid from 7.3% in 1997 to -7.4% in 1998, while South Korea’s contracted from 6.2% to -5.1%.

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Bankruptcies and Financial Sector Collapse

With limited regulatory enforcement, financial institutions borrowed too much short-term foreign debt. The excessive borrowing and risky investments, combined with currency devaluation and capital flight, caused many banks and businesses to default on their loans.

Political instability

The economic hardships and public discontent led to significant political changes. In Indonesia, long-time President Suharto was forced to resign after 31 years in power. South Korea and Thailand also saw political upheaval and changes in leadership.

IMF and International Aid

During the financial crisis, The International Monetary Fund (IMF) and the World Bank, among others, provided bailout packages of about $118 billion to the worst-hit countries, including Thailand, Indonesia, and South Korea. These packages came with stringent conditions that required affected countries to restructure their economies including strengthening weak financial systems, lowering debt levels, raising interest rates to stabilize currencies, and cutting government spending.

References

Alice, D.B 2024, Asian financial crisis, Britannica Money, available at <https://www.britannica.com/money/Asian-financial-crisis>.

Asian Development Bank 2001, Can “Moral Hazard” Explain the Asian Crises?, Asian Development Bank, available at <https://www.adb.org/publications/can-moral-hazard-explain-asian-crises#:~:text=Following%20an%20insightful%20paper%20by,quite%20a%20compelling%20stylized%20story.>.

Federal Reserve History n.d., Asian Financial Crisis, Federal Reserve History, available at <https://www.federalreservehistory.org/essays/asian-financial-crisis>.

Investopedia 2024, Asian Financial Crisis: Causes, Response, Lessons Learned, Investopedia, available at <https://www.investopedia.com/terms/a/asian-financial-crisis.asp>.