Study of Asian Financial Crisis 1997

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A study of Asian Financial Crisis of 1997

Indian Institute of Management Lucknow

Submitted by

Rachit Khare PGP28227

Aditya PGP28233

Akshat goel PGP28256

Supriya Sharan PGP28264

Kapil khandelwal PGP28274

Divya Chnadra PGP28278

Sudeep Sahu PGP28279


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Abstract

The summer of 1997 saw South East Asian nation plunge in to a deep state of financial crisis. The

crisis soon turned in to a global one in a period of 1 year. Unlike previous turbulences of Mexico and

European Monetary system of early 90s Asian crisis surprised everyone with its scale and depth. Amajor reason was the exemplary growth rate and economic success of over 2 decade in South East

Asian region. Since 1970s no other group of nation had produced such rapid and consistent growth.

All these facts provoke a number of questions about the entire dynamics of this crisis.

Main reasons identified by the study for the Asian crisis are reliance of short term capital and

sudden reversal of the same, weakness in external sector and a weak domestic financial sector.

Almost all these reasons were common to entire region which also explains the contagion among

nations. IMF played a very critical role in resolution of the crisis and report presents a discussion on

the same.

The Asian crisis also raises the important question of finding a balance of capital access,

liberalization and instability associated with it. It has also raised doubt over choice of pegged

exchange rate in a world of increasing capital mobility. Major lessons from the crisis is listed and

discussed in concluding chapter of the report.


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INDEX

S.No Topic Page No.

1 Introduction 4

2 Factors responsible for the crisis 6

3 Events of the crisis 12

4. Impact of the crisis and IMFs role 14

5 Lessons from the crisis 23

6 Source of data and References 26


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1. Introduction1.0introduction

The Asian financial crisis was a period that gripped much of Asia beginning in July 1997, and raised

fears of a worldwide economic meltdown due to financial contagion. It hit the most rapidly growing

economies in the world and prompted the largest financial bailouts in history till that time. It was

largely unanticipated and took observers by surprise since it occurred in "Asian tiger economies"

whose macroeconomic policies had in most cases been praised as relatively sound. This is exactly

the reason which prompted a major review of macroeconomic policies of many emerging countries

in next decade. The crisis also became testament to the shortcomings of the international capital

markets and their vulnerability to sudden reversals of market confidence while raising doubts about

IMFs approach to managing financial turmoil.

Indonesia, South Korea and Thailand were the countries most affected by the crisis. Hong Kong,

Malaysia, Laos and the Philippines were also hurt by the slump. China, Taiwan, Singapore, Brunei

and Vietnam were less affected, although all of them suffered from a loss of demand and

confidence. The countries, which had enjoyed a long period of high growth rates saw their

currencies plunge in value and their economies in crisis that threw many of their citizens back into

poverty.

Figure 1 South East Asian Crisis of 1997: affected countries


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1.1SE Asian nations before the crisisUntil the advent of the crisis in 1997 SE Asian Nations were held in high regard for their sustained

growth rates and stable economic development of more than 2 decades. They used to be lauded as

a paradigm to follow for other developing nations. Figure 2 presents the GDP growth rates of period

for these nations -

Figure 2 annual GDP growth rates in %It is evident from the figure that these countries sustained a very high growth rate of 7 10 % for

more than 20 years consistently. These nations were the only group to have closed the gap with

developed economies over the past few decades. Such stellar growth was characterized by the rapid

output and productivity growth in agriculture, huge investments in education and healthcare and

focus on exports. A semi-authoritarian political regime in most countries ensured political stability

and decision-making were faster and comprehensive unlike democratic regimes. Government

policies were market friendly and liberalized investment flows which saw huge cheap private capital

investments. At the same time the economies of Southeast Asia in particular maintained high

interest rates attractive to foreign investors looking for a high rate of return thus ensuring a high

availability of capital. In fact SE Asia attracted almost half of the total capital inflows in the preceding

years of crisis.

-15.00

-10.00

-5.00

0.00

5.00

10.00

15.00

20.00

1970 1975 1980 1985 1990 1995

annual GDP growth rate %

Thailand Hong Kong SAR, China

Korea, Rep. MalaysiaIndonesia Philippines

Singapore


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2.0Factors responsible for the crisis2.1External sector issues

A glance over table 1 of current account deficit (CAD) of Asian countries immediately highlights one

of the most prominent causes of the crisis- high CAD coupled with misaligned exchange rates. Most

of these Asian economies ran a huge deficit as a percentage of GDP in years leading up to crisis.

Thailands CAD was unsustainably high at 8 % of GDP in year 1995 and 1996. Malaysian CAD

averaged 5 % during 1990 96 periods. These deficits were financed by large foreign capital inflows

which was short term in nature.

Table 1 CAD of SE countries Source World Bank databank

1999 1998 1997 1996 1995 1994 1993 1992 1991 1990

Thailand 10.1 12.7 -2 -8.1 -8.1 -5.6 -5.1 -5.7 -7.7 -8.5

Indonesia 4.1 4.3 -2.3 -3.4 -3.2 -1.6 -1.3 -2 -3.3 -2.6

Korea, Rep. 5.5 12.3 -1.6 -4.1 -1.5 -0.8 0.8 -0.7 -2.4 -0.5

Malaysia 15.9 13.2 -5.9 -4.4 -9.7 -6.1 -4.5 -3.7 -8.5 -2

Philippines -3.5 2.1 -5.3 -4.8 -2.7 -4.6 -5.5 -1.9 -2.3 -6.1

Countries which have largest CAD suffered the most in the form of currency collapses. However

Countries such as Hong Kong and Taiwan with positive low negative current account balance also

saw their currencies tumble which indicate that CAD alone is not sufficient in explain the crisis. Most

of the countries in S E Asia pegged their currencies against US$. Data presented in table 2 shows

that nominal exchange rates for all the nations fluctuated within very narrow range during 1990

96. From the middle of the decade US $ kept on appreciating against Japanese Yen as shown in

chart. By the end of 1996 it had appreciated close to 50 % against Yen (refer fig 1). Since Japan is the

largest economy and a major export hub and trading partner for other economies in Asia, this

situation exerted downward pressure on other Asian currency as well. As a result export driven

economies of Asian nations suffered significant decline in competitiveness. This eventually


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aggravated their CAD issues further apart from putting capital account under strain due to

expectation of lower returns.

Figure 3 US$ exchange rates for JPY Source World Bank databank

Table 3 presents the consumer inflation figures for SE Asian Nations for period 1990 99 in

comparison with USA. It highlights the fact that inflation rates in SE Asian nations remained

consistently high with respect to USA. It meant that real exchange rates in most countries

appreciated leading to loss in competitiveness of their exports (refer table 4).

Table 3 annual consumer Inflation %

1998 1997 1996 1995 1994 1993 1992 1991 1990

Thailand 7.99 5.63 5.81 5.82 5.05 3.31 4.14 5.71 5.86

Malaysia 5.27 2.66 3.49 3.45 3.72 3.54 4.77 4.36 2.62

Korea, Rep. 7.51 4.45 4.92 4.48 6.26 4.75 6.31 9.3 8.58

Indonesia 58.39 6.23 7.97 9.43 8.52 9.69 7.53 9.42 7.81

Philippines 9.27 5.59 7.51 6.71 8.36 6.88 8.59 18.49 12.68

USA 1.6 2.3 2.9 2.8 2.6 3 3 4.2 5.4

Table 2 Nominal Exchnage rates , Per US$ , period average Source World Bank databank

Countries 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990

Thailand 37.81 41.36 31.36 25.34 24.92 25.15 25.32 25.40 25.52 25.59

Indonesia 7855.15 10013.62 2909.38 2342.30 2248.61 2160.75 2087.10 2029.92 1950.32 1842.81

Korea, Rep. 1188.82 1401.44 951.29 804.45 771.27 803.45 802.67 780.65 733.35 707.76

Malaysia 3.80 3.92 2.81 2.52 2.50 2.62 2.57 2.55 2.75 2.70

Philippines 39.09 40.89 29.47 26.22 25.71 26.42 27.12 25.51 27.48 24.31


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Table 4 Real exchange rates

2.2Dependence on short term capital inflowDriving a large part of their capital inflows were lending booms due to higher yields in these

emerging economies, which led domestic banks in a number of these economies to actively seek

foreign funds from the West to finance the lending. The banks were motivated by the prospect of

large profits, especially as they could take advantage of fixed exchange rates in order to reduce the

cost of this borrowing. The same motives led blue chip companies to borrow excessively from

overseas, rather than pay higher domestic interest rates. Even Asian borrowers with sound

businesses would raise capital abroad to finance industrial development. This situation was most

prominent in Korea where large Chaebols relied excessively on easily available debt as opposed to

stable equity investments.

The sustainability of current account deficit also depends a lot on nature of capital inflows. Short

term capital borrowing (loans less than of 1 years duration) is inherently more volatile compared to

long term inflows. Similarly FDI is considered to be more stable than debt inflows. Table 5 presents

short term debt as % of total debt for SE nations. It can be seen that the most affected nations had

unusually large fraction of short term debts.


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Table 5 short term debt as % of total external debt

Table 6 annual capital flows as % of GDP

198388 198995 1991 1992 1993 1994 1995 1996 1997

Indonesia

Net Private

capital flow1.5 4.2 4.6 2.5 3.1 3.9 6.2 6.3 1.6

Net direct investment 0.4 1.3 1.2 1.2 1.2 1.4 2.3 2.8 2

Net portfolio

investment 0.1 0.4 1.1 0.6 0.7 0.8 0.4Other net investment 1 2.6 3.5 1.4 0.7 1.9 3.1 2.7 0.1

Thailand

Net Private

capital flow3.1 10.2 10.7 8.7 8.4 8.6 12.7 9.3 10.9

Net direct investment 0.8 1.5 1.5 1.4 1.1 0.7 0.7 0.9 1.3

Net portfolio

investment0.7 1.3 0.5 3.2 0.9 1.9 0.6 0.4

Other net investment 1.5 7.4 9.2 6.8 4.1 7 10 7.7 12.6

Philippines

Net Private

capital flow2.0 2.7 1.6 2 2.6 5 4.6 9.8 0.5

Net direct investment 0.7 1.6 1.2 1.3 1.6 2 1.8 1.6 1.4Net portfolio

investment 0.2 0.3 0.1 0.1 0.4 0.3 0.2 5.3

Other net investment 2.7 0.9 0.2 0.6 1.1 2.5 2.4 8.5 4.5

Korea

Net Private

capital flow1.1 2.1 2.2 2.4 1.6 3.1 3.9 4.9 2.8


Net portfolio

investment0.3 1.4 1.1 1.9 3.2 1.8 1.9 2.3 0.3

Other net investment 1.6 0.8 1.3 0.7 1.5 1.7 2.5 3 3.4

Malaysia

Net Privatecapital flow

3.1 8.8 11.2 15.1 17.4 1.5 8.8 9.6 4.7


Net portfolio

investment- - - - - - - - -

Other net investment 0.8 2.3 2.9 6.2 9.7 4.2 4.1 4.5 0.6


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Table 6 provides an indication the size of the capital inflows into the Asian Crisis economies. Capital

inflows from the private sector are shown, broken down between foreign direct investments (FDI)

made for the purposes of ownership (for example in factories) and portfolio investment in financial

markets. Inflows in the form of FDI are long term in nature and add to productive capacity.

However, inflows in the form of portfolio investments or short-term deposits/borrowing can be

destabilizing. It is evident that dominant fraction of flow was of short term commercial bank lending.

Such large surge of short term capital inflows led to surge in macroeconomic variables such as

exchange rates and prices of assets like property and shares away from long term equilibrium while

presenting a risk of sudden reversal without an advance warning. Table 7 presents the extent of this

sudden reversal in five Asian economies (Indonesia, Korea, Malaysia, Philippines, and Thailand). Net

private flow of capital dropped by 109 billion US$ between 1996 and 1997 and led to a massive

contractionary shock for the economy.Table 7 external financing of Asian nations

It is important to highlight here that most of the short term capital inflow was in real estate sector

hence funded asset prices inflation. Only a small proportion of this capital was invested in

manufacturing and other productive activities. This phenomenon contributed in worsening of

current account deficit as it did not generate foreign exchange by fuelling export.


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2.3Weak financial sector

During the early 90s financial sector witnessed a wave of liberalization. Laws which restricted flow of

capital were abolished and tax incentives were started for offshore borrowing. However these

changes were largely unsupported in terms of macroeconomic structural reforms. For example

capital account opening in a number of countries allowed banks, but restricted business enterprises

to borrow liberally in international markets. This practice encouraged large flow of short term

capital. Moreover insufficient regulations meant that insufficient capital adequacy ratio, abnormal

lending limits, inadequate asset classification system, poor transparency and provisioning for bad

debts were the norm in financial sectors of these countries .This laxity allowed unsound and possibly

corrupt relationships to develop. In Korea, for example, it was not unusual that one division of a

chaebol would be a bank, lending to other divisions of the same Chaebol. With easy access to funds,

it is no surprise that some investments were made in dubious ventures which later gave rise to hugeamount of non-performing loans. It is also important to note that with rapid growth of lending,

banking institutions could not add the necessary managerial capital (well-trained loan officers, risk-

assessment systems, etc.) fast enough to enable these institutions to screen and monitor these new

loans appropriately. At the same time many observer points towards presence of Moral hazard in

these nations. It is argues that even if there was no explicit government safety net for the banking

system, there clearly was an implicit safety net. Depositors and foreign lenders to the banks in East

Asia knew that there were likely to be government bailouts to protect them.

It is suggested that there are two ways in which problems in the banking sector can lead to a

financial crisis in emerging market countries like those in East Asia. First, the deterioration in the

balance sheets of banking firms can lead them to restrict their lending in order to improve their

capital ratios or can even lead to a full-scale banking crisis which forces many banks into insolvency,

thereby directly removing the ability of the banking sector to make loans. Second, the deterioration

in bank balance sheets can promote a currency crisis because it becomes very difficult for the

central bank to defend its currency against speculative attacks which eventually took place in SE

Asia. As the debt contracts in these economies were usually denominated in foreign currency

whereas assets were denominated in domestic currency. Currency devaluation further worsened

the balance sheets of banks due to increased tendency to default. It eventually led to collapse in

financial sector in SE Asia.


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3.0 Events of the crisis3.1The Unfolding of events

The most prominent date during this crisis was July 2nd 1997 when free floating of Thai Baht was

announced which led to its immediate devaluation of 20%. This decision was forced due to lack of

foreign currency to support its fixed exchange rate. Philippines, Malaysia, Indonesia and South Korea

abandoned the defense of the currency soon thereafter. By January of 1998, currencies of all of

these countries had suffered a tremendous decline and led to collapse of financial sector thus

crippling the economy.

Following is the table which enlists the major events of the entire crisis period in chronological

order.

Table 8 Events' chronology

Month/year Events Remarks

Late 1996

Thai Exports began to stumble

while boom in Thai real estate

continued

Speculators began attacking Thai currency

1996 and

early 1997

The Thai Baht faces speculative

attacksFall of stock market throughout the year

Early 1997Seven Bankruptcies of Korean

'Chaebol' enterprises

Huge shockwaves as Korean Economy is built

around Chaebols

May - June

1997

Thai Financial system under

severe pressure

16 NBFCs were shut down by June; a further 48

were to follow by the end of the year. Central

bank's refusal to act as lender of the last resort led

to loss in foreign investor's confidence.

July 2, 1997Thai Baht is free floated,

currency defense is abandonedTo avoid default in international debt

JUL - Aug

1997

Philippines abandons its

currency defense. Indonesian

Ruppia followed in Aug

Financial contagion spreads

Aug-97

IMF rescue package of 17.2

Billion $ announced for

Thailand

Thailand agrees to adopt tough economic measures

proposed by the IMF. The Thai government closes

42 ailing finance companies and imposes tax hikes

as part of the IMF's insistence on austerity.

Aug-97Hong Kong Dollar under

speculative attack

Oct-97

Further devaluations in

Thailand, Indonesia, Malaysia

and Philippines


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Oct-97Taiwan forced to devalue its

currency

Oct-97

Hong Kong Stock Exchange

wipes $29.3 billion off the

value of stock shares.

Hong Kong's stock index falls 10.4% after it raises

bank lending rates to 300% to fend off speculative

attacks on the Hong Kong dollar

Nov-97 Indonesia finalizes deal withIMF for funding of 42.3 Billion $

Nov-97Korean Won collapsed under

speculative attacks

Bank of Korea allows the won to fall below 1000

against the dollar (record low)

December 4,

1997

IMF rescue package of 58.2

Billion $ for South KoreaKorean currency switched to floating on Dec 16th

Dec-97

the Thai government closes 56

insolvent finance companies

(30,000 white collar jobs lost)

Jan - Apr

1998

brief period of stabilization in

markets

May-98change of government in

Indonesia and Philippines

Jun-98

Japan announces that its

economy is in a recession, Yen

falls to levels near 144 to the

dollar.

US intervention to support Japanese Yen

Jul - Aug

1998

Sharp fall (~25%) in western

stock markets

Russia in trouble, Monetary authorities impose 90

day moratorium over foreign currency debt.

Sep-98Russia abandons defense of

currency

Russian Government defaults on its obligations in

September.

Sep-98Korea lowers short term

interest ratesEconomic activity slows down.

2001Recovery starts to take

concrete foothold

South Korea announced the end of crisis in dec

1999, Thailand recovered and paid its IMF loans

well ahead of schedule in 2001.


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4. Impact of the crisis and IMFs role4.1Impact on world economy:

During the mid of 1997 the South-East Asian economies began to slow down. Within a year it all

spread around and became a global problem. What looked like a regional problem troubled the

global economy. During July, 1997 Thai Baht was devaluated. It was followed by Philipines Peso and

Malaysian Ringgit. Soon Indonesian Rupiah also became floating currency. During October financial

systems of these economies started to tremble. By August 1998, Japan was into recession. There

were concerns that Japan might fail to pursue adequate banking and financial reforms. This led to

much devaluation of Japanese yen. Russia was also in slowdown with the collapse of Rouble. The

crisis in Russia led to rapid contagion in Latin America with the currencies in Brazil, Venezuela and

several other Latin American economies coming under speculative pressures. This also affected the

capital markets in United States and Europe. The financial institutions in Russia and emerging

markets suffered huge losses. Hedge fund and long term capital management nearly failed. This led

to severe liquidity crunch in United States. By September 1998 economies looked into face of global

recession. Growth rate of economies all over the world fell down.

The Thailand, Indonesia, and South Korea were nearly collapsing and depended on IMF to save

them. Japanese economy was in complete turmoil and heading into recession. There was no doubt

that the regional crisis had started to affect the rest of the world. The major impact of the crisis

globally can be underlined by following points:

a. Economic growth:Looking at the situation of the crisis it was inevitable that a global turmoil was to follow. In May

1998 the IMF noted- The impact of the Asian crisis on growth prospects for the major industrial

countries, with the important exception of Japan, is expected to be modest. Exports to Asia are

likely to fall sharply, but the declines in bond yields in most industrial countries since mid-1997 -

reflecting reduced expectations of inflationand of monetary tightening as well as a portfolio shift

away from emergingmarket investments - are likely to have an offsetting and simulative effect on

growth. Furthermore, equity prices in the most major markets reached new peaks in March. As global economy is completely entwined the exact impact on various economies from Asian crisis

is difficult to bring about. International factors and domestic factors both work with each other to

shape a nations economic growth. Still economies all around the world even Britan, United States

etc. were slowing down in 1998. There was no doubt that there were global ramifications of that

economic crisis.


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b. Fall of Equity Markets:

When equity markets in South East Asia fell, they caused a negative wealth effect on investors

across the world, just as they had upon investors from South East Asia itself. Furthermore, these

stock market falls directly initiated market declines across the globe. To a large extent, the size of

any negative wealth effect on the major nations depended on the size of their holdings in South East

Asia prior to the crisis. In the UK, pension funds had about 5% of their assets, approximately $50

billion, in the Pacific region excluding Japan just before the Asian Crisis. Flows from the US into the

regions equity markets amounted to $33 billion in the four years from 1993 and 1996. Japan was

the most exposed western economy to South East Asian markets. For a country already burdened by

a domestic banking crisis, the impact of a negative wealth effect was doubly severe. Some investors

managed, for one reason or another, to avoid some of the collapse in South East Asian markets by

repatriating funds before the crisis emerged. Less prescient western financial institutions, havingseen the value of their South East Asian assets decline once the crisis began, tried to get their money

out of these countries. However, this depressed the markets further prompting to more sales. The

interesting part is that the losses made by financial institutions in South East Asian markets were

less compared to losses made in their domestic markets. This happened despite the large portfolios

held by them in these markets. The direct financial effects of the Asian Crisis would have been

limited, if they had not triggered falls in other equity markets, especially in Japan.

c. International Trade: Another obvious effect on industrialized countries of the Asian Crisis was to

be an income effect caused by falling international trade. Because South East Asian currencies

were devalued, there was a weakening of demand for western goods in these countries, which are

relatively more expensive. Western goods were likely to be relatively more expensive in third-party

countries as well. There was a brake on the growth of exports from the major economies.

As with the other consequences of the Asian Crisis, different industrialized economies were exposed

to different degrees. For example, in 1996, the combined value of imports from and exports to the

Asian Tigers amounted to about 5% of GDP in Japan, but only on average 1% of GDP in Europe and

3% in the US.66 An indication of the importance of trade with South East Asia to the western

economies is shown in table 1 below :


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Table 9 Trade with South East Asia in 1996

Share of all trades conducted with Asian

crisis economies

Trade as proportion of

GDP

United States 16.3% 13.2%

Japan 30.4% 12%

Germany 5.5% 27%

France 4.3% 29.7%

Italy 4.3% 22.6%

United Kingdom 7.7% 30.3%

Canada 4% 43%

The fall in South East Asian product prices to global consumers was significant. South East Asian

producers were desperate to maintain demand as close to pre-crisis levels as possible by cutting

prices. Western manufacturers were pressurized into reducing their prices in order to maintain their

competitiveness with these South East Asian imports.

c. Foreign Direct Investment: While depreciating currencies gave a competitive trade advantage

to South East Asian companies, the cost of acquiring overseas assets was increased at the same

time. At the same time companies faced a shortage of available funds. As a result, foreign direct

investment projects were cut back severely. The UK had been a particularly large recipient of foreign

direct investment from South East Asia in those years, and the announcements of delay or

termination of projects by Korean companies, such as Samsung and LG Electronics, was highly

publicized.

The impact on individual countries mostly depended on their exposure to South East Asian

economies. But even countries with little exposure to these economies suffered because of third

party nations. But it is well accepted that slow down impact was more in US as compared to

continental Europe.

4.2South East Asian Crisis and IndiaSince 1960 till 1990 the tiger economies put on show impressive economic performance. Their

macro-economic policies where prudent and growth figures were extremely impressive. Some

economists had already argued that a slowdown was on card for these countries. Still the depth and

impact of the crisis came as a nasty surprise for global economy. Thailand, Indonesia, Malaysia and


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South Korea were the most affected nations. The trade impact of the crisis was all over other Asian

nations. And the heat was felt throughout the globe. Among the massacre of currencies and

financial markets India remained largely unaffected despite being very close to ASEAN nations. The

following impact was felt on Indian economy during crisis:

Impact on exchange rates: India did not face any currency devaluation as faced by Thailand,

Malaysia etc. Still some repercussions were felt on Indian currency also. The average dollar rate in

June 1997 was Rs 35.81, which increased to Rs 36.43 in September 1997 but improved to Rs 36.22 in

October 1997. It was only during November 1997 when intense pressure on the rupee started

building up and, as a result, the dollar rate increased considerably in the subsequent period to reach

Rs 39.4 in January 1998. It is difficult, however to attribute the noticeable though relatively much

smaller depreciation of about 8 per cent in Indian rupee during the period from November 1997 to

January 1998 to the East Asian contagion effect, since the same period was essentially characterized

by major political uncertainties arising from the announcement of mid-term polls. Thus, the Indian

currency has for all practical purposes remained quite insulated from the East Asian virus.

Impact on Stock Markets: As already mentioned that India suffered very little from the crisis. Still

the sector which was most affected by the crisis was Stock markets. In June 1997 Sensex was

touching new heights with a level of 4256. This was a result of positive sentiment created by P.

Chidambarams dream budget. By august 1997 the Sensex had fallen down to 3876, a fall by roughly

9%. But Sensex partially recovered to 3934 by mid of October. This makes it a net fall of 7.6%. In

hindsight we can see that this kind of fluctuations has become very much part of Sensex itself.

It is also noticeable that Sensex fall to 3224 by January 1998. One may argue that this 18% fall was a

direct implication of the on-going crisis. But this argument can easily rebuffed with the fact that

after general elections that Sensex was at 4000 level by April of 1998. It is evident that fall of stock

markets was majorly due to political uncertainties i.e. the fear of mid-term elections.

One fact that strongly supports the above argument is the pattern of FIIs stock market during July

1997 to April 1998. From July to Oct 1997 the net inflows in Indian stock markets were $ 860 million.

But from Oct 1997 to January 1998 net flows were negative.

Impact on exports and imports: India suffered some increase in trade deficit as a result of the crisis.

But compared to overall magnitude of foreign trade of India the losses were negligible. During that

period aggregate trade deficit with Thailand, Indonesia, Malaysia, South Korea increased from 0.56 $

billion to $ 1.34 billion.


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By analysis of above factors we see that the net impact on India by the crisis was not significant. The

reasons why India remained untouched by the crisis can be grouped as follows:

1. No miracle no shocks The economies of South East Asian grew a lot from the 7th decade of

century. The development they put on show became exemplary for other developing economies.

The severity of the Asian financial crisis came as a genuine surprise to many in the international

community because the crisis was faced by the countries that were the very economies that had

achieved the East Asian miracle. The East Asian miracle that saw the transformation East Asian

economies. From poor, largely rural less-developed countries to middle-income emerging markets

has been one of the most remarkable success stories in economic history. Scholars assert that the

East Asian miracle was real, as not only had GDP significantly increased, but poverty had decreased,

and literacy rates as well as health indicators had improved.

If we compare this with Indian economy there was nothing to boast of during these decades. Wecontinued to fight poverty and hunger. No exemplary growth was achieved during these years.

When these economies grew by 6-10% growth rate Indian economy was crawling with growth rate

as low as 2%. With continued growth the south East Asian economies over did what led them to the

path of growth. The very factors that were part of their prized economic policies i.e. open access to

overseas capital, full capital convertibility pushed them into crisis. In Indian economy any factor

whatsoever was absent which could have overheated the economy or given Indian Economy the

overexposure to outside factors. Already lowly valued Indian currency did not have much scope for

speculative attacks. Before Asian crisis many economic speculated the advent of a slow-down. They

saw the situation as bubble in making. As these economies were overdoing everything, and losing

the balance which was extremely necessary to be kept.

2. Absence of full capital account convertibility- According to the Tarapore Committee (1997) full

capital account convertibility (CAC) is defined as "the freedom to convert local financial assets into

foreign financial assets and vice-versa at market determined rates of exchange". In other words, CAC

implies complete mobility of capital across countries. Unlike south East Asian economies which

faced the crisis India did not allowed full capital convertibility. This policy very much curbed the

impact of excessive dependence of foreign capital. It also limited Indias exposure to outside

fluctuations.

3. No fixed exchange rate Full capital account convertibility coupled with fixed exchange rate

was a combination with worked bad for tiger economies. When crisis triggered their foreign


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reserves depleted very quickly. Had there been a floating exchange rate, the shocks brought about

by currency devaluations could have been easier to curb.

India already had a floating exchange rate. This kept imports/exports competitiveness related to

exchange rates in check.

4. Strong fundamentals and relatively closed economy This is mostly widely believed reason to

have saved India from South East Asian crisis as well as Subprime crisis. We have an economy largely

closed by various policies and checks. India did not embraced globalization overnight. Here change is

taking place in step by step manner. Democratic government is one major reason behind it. In South

East Asian economies the regimes were mostly semi autocratic. The decisions taken by them were

quick. They whole heartedly accepted the open economy model. Outside capital and investments

helped them to grow quickly. Moreover because of the initially small size of the economies foreign

capitals were able to alter them basics of economies in faster pace. Indian economy was largelydriven by domestic demands and it still is. That made the effect of outside shocks almost null for

India.

5. Declining external debt to GDP and quality of external debt Compared to South East Asian

economies India did not have that level of external debt. Moreover the debt was largely long term.

The crisis nations have large chunks of short term debts which worsened their situation.

4.3Role of IMFInternational Monetary Fund injected liquidity into the markets; and tried to take situation into

hands to control it. The IMFs policy had a number of key elements: financial assistance, a package

of austerity measures and re-structuring of the economy. These elements are discussed as below:

1. Financial assistance- The rescue funding for the Asian Crisis economies was organised by the

IMF over the course of the second half of 1997.54. The need for international assistance to stricken

economies is usually only triggered when there is a danger of sovereign default. In trying to defend

their currencies from speculation, the Thai, Korean and Indonesian governments were in danger of

defaulting on their repayment commitments by late 1997 and thus needed aid.

Table 10 IMF funding details: (in $ Billions)

IMF Multilateral Bilateral Total IMF Administered Disbursements

Indonesia 9.9 8 18.7 36.6 4

Korea 20.9 14 23.3 58.2 17

Thailand 3.9 2.7 10.5 17.1 2.8

total 34.7 24.7 52.5 111.9 23.8


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Multilateral funding was the funding jointly promised by World Bank and Asian development bank.

Bilateral funding were funding pledged by individual nations. These rescue packages were notionally

for the public sector in the affected countries. At $112 billion, the total value of the rescue packages

for Indonesia, Malaysia and Thailand was more than twice the size of the $50.8 billion aid that was

arranged for the Mexican bailout in 1994.

2. Austerity ProgrammeIn return for the international aid, all receiving nations invariably agree to conditions about

macroeconomic policies to be followed and structural reforms to be implemented. The IMFs

macroeconomic proposals consisted of setting targets for the permissible size of future budget

deficits and tightening monetary policy. These contractionary policies were considered necessary

following devaluation, to prevent higher import prices being translated into higher export prices and

thus causing the erosion of competitiveness gains.3. Restructuring:Accompanying the rescue package and the macroeconomic prescriptions, the IMF also tried to

correct a number of structural weaknesses in the South East Asian economies. There is widespread

agreement that in the long term the main task facing governments in the countries most affected

by financial turmoil was to ensure that adjustment policies to tackle problems at their roots be

implemented as rapidly and effectively as possible.

The aim of such structural reforms was to remove features of the economy that had become

impediments to growth, such as monopolies, trade barriers and non-transparent corporate

practices. Immediate action was taken to correct the weaknesses in the financial system. While

tailored to the needs of individual countries, the IMF programs arranged for:

The closure of unviable financial institutions, with the associated write down of shareholders

capital;

The re-capitalisation of undercapitalised institutions;

Close supervision of weak institutions;

Increased potential for foreign participation in domestic financial systems.

4.4Criticism of IMF:As mentioned above it was deemed necessary by IMF to implement contractionary economic

policies. Their argument was that Pain is necessary to bring the economies back on track. They

defended the policy of high interest rates, tight monetary policies, and cuts in the government

budget. Many economists argue that the deep recession which followed in Thailand, Malaysia etc


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was because of these policies. The companies in these nations already were grappling with low stock

prices and depreciated currencies; there backs were broken by high interest rates. Many small

companies which earlier did not had exposure to outside capital had started to suffer afresh by lack

of liquidity in markets, spending cuts and high interest rates. In Thailand interest rates rose as high

as 18% rendering it counterproductive for all practical purposes.

Other reason of IMF criticism was the contradictory stands taken by it. Before the crisis started IMF

along with other World Bank and western nations had lauded the economic models of south East

Asian economies. During Maxican Peso crisis in 1994 nobody noted the weaknesses possible in

South East Asian economies. Around 1993 the World Bank itself toppled the term East Asian

Miracle. But just after the crisis whole blame was pushed on to these nations. Domestic factors like

poor management of banks and financial institutions, over speculation in real-estate, the collusion

between businesses and govts, fixed exchange rates and high current account deficit everything wascriticized. The role of external factors such as poor judgements of huge institutional investors,

currency speculation in global markets etc was ignored.

It can be argued that this only was the whole idea behind IMFs package. Change policies and

domestic model completely because this only was the claimed reason of crisis. On the other hand

when Japanese yen was falling, Japan was severely criticized for not reflating its economy. Interest

rate in Japan remained low only (around 0.5%). Nobody asked Japan to increase its interest rates.

Instead Japan was repeatedly advice to take expansionary fiscal measures to improve economy.

This was criticized a display of double standards is because it was in the rich countries' interests to

prevent a Japanese slump that could spread to their shores, and so they insisted that Japan reflates

its economy whilst keeping its interest rate at rock bottom. Whereas in the case of the other East

Asian countries, which owed a great deal to the Western banks, the recovery and repayment of their

foreign loans was the paramount interest.

4.5Our view point:1. Essential follies of Business CyclesWhenever there is some sort of economic crisis it is deeply studied afterwards. Many conclusions

are drawn over it. Many new theories are formed and many new lessons are learnt from the past.

Mistakes are kept in mind so as not be repeated again. Still some crisis every decade or so keep

happening. In our analysis we saw that the factors that led to financial crisis were clearly present in

the system beforehand. In fact similar crisis (related to currency devaluations) had taken place in

Mexico and Scandinavian nation just some years ago. Figures were openly available to everyone.


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Prominent economists like Paul Krugman had already expressed their negative concerns for the

South East Asian economies. But nobody heeded to these facts before the crisis took place. It is true

that the exact nature and impact of the crisis is difficult to project. But signs of overdoing some

things are definitely present. Still one cannot do anything to keep economies stable always.

Slowdowns are essential part of economic cycles, bound to take place. Similarly the treatments

given after crisis are also almost always criticized. It is difficult to judge whether the treatment

which was not given would have done better than the applied one.

2. Need of Bare minimum International standardsFinancial Liberalization and Globalizations had make the current economic scenarios very complex.

It had become very difficult to assess the impact of anything completely. There are no standards as

to how things are to be done in economies as well as in International markets. Speculation over

virtually everything drives things haywire every now and then. Some financial institutions oreconomies behave in a manner which hurt overall good. It is of utmost important that things are

streamlined in present global economies. Standards for capital flows, foreign investments, exchange

rates, and trades should be created. The present bodies like IMF, World Bank, WTO etc. need to

bring in more transparency. They need to take concrete steps to improve their credibility and

implement new standards about the ways global finances will be governed in future. One good step

towards this is Basel standards for banking.

3. Rising global economy need global governanceWhile the world is increasingly becoming a single market like entity individual economies are swiftly

transforming with it. From South East Asian crisis we understood that how Asian economies

transformed themselves and moved on growth path. But during this transformation things might

take place either to slow or too fast. Similarly developing nations might be pressurized by developed

nations to follow what suit their best interests. Global interactions may go too complex and will not

stop themselves till they are profitable for economies. Here we need a strong body implementing

global economic governance. A body which can keep in mind the overall balance of world economy.

A body which slowly develops into watch keeper of macro-economic indicators for individual as well

as world economy.


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5.0 Lessons from the crisis5.1Risks with fixed exchange rates

South East Asian nations had their currency pegged with US dollar which was part of the strategy to

control inflation. In a fixed exchange rate, one need to keep inflation low; otherwise the currency

will start to fall below the target level. It provides a highly visible and strong commitment and thus

raises the political costs of loose monetary and fiscal policies. It enables firms to plan ahead because

they know future costs and prices of exports and imports. Hence it makes trade and investments

between countries easier and more predictable.

Asian crisis demonstrated the risks of fixed exchange rates for an economy which has large debts

denominated in foreign currency. Under fixed exchange regime, value of domestic currency

undergoes a much larger, rapid and unanticipated decline in the event of a successful speculative

attack. In Asian crisis Indonesia which was one of the worst hit nation, saw its currency plummet to

less than 25 % of its pre-crisis value. Such large fall in value of domestic currency can translate in

disaster for firms with foreign currency loans and eventually lead to bad debts for banking system

paving the way for financial sector collapse.

A fixed exchange rate can instill false sense of lower risk and encourage capital inflows due to its

stability. It can lead to large stimulation in economic growth if channeled in productive assets

creation. However on the flip side such large capital inflows can generate a fatal combination with a

weak financial sector which was the case with emerging Asian economies. On The other hand

flexible exchange rates discourage short term excessive capital flows due to inherent fluctuations of

rates. Hence economies with a fragile banking system and huge debts denominated in foreign must

switch from fixed exchange regime.

5.2Strengthening of financial system in emerging economies A very immediate lesson that can be drawn from the crisis is to strengthen the financial systems

structure. For example stronger supervision which would involve monitoring on how banks raise

funds in domestic and foreign markets. Their capital adequacy ratios need to be enforced stringently

and transparency must be brought in declaring and classifying non-performing loans.

A common characteristic among all nations was encouragement for behind-the-scene mechanisms

for loan allotments. For example whether its government linked banks in Indonesia, chaebol

controlled banks in Korea or dubious non-banking finance companies of Thailand, in all cases fund

allocations were done on personal / business relationships or government influences without any


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regard to repay-ability. Such practices are criticized as crony capitalism. This eventually led to

non-performing loans and acted as one of the major causes.

At the same time its prudent to develop a balanced financial market. Its important to highlight here

that Asian economy have a very high savings culture in comparison to developed western

economies (refer table 1). The high amounts of savings were essentially on-lent by banks to

businesses. The region has traditionally relied heavily on the banking sector rather than on capital

markets. The size of the bond market in Asia is under 20 per cent of the regions GDP which is low

by comparison with industrial country bond markets. For instance, the US bond market is over 100

per cent of GDP. This in turn was largely responsible for these nations high-debt and high-risk

model of economic development. This is also responsible for high levels of leverage, compared with

countries having brisk growth and more balanced financial systems that is, those that have

developed equity and bond markets. When in early 1997 The Fed in USA increased short terminterests international investors reassessed their prospects in these countries and consequently

stock markets fell. Investors looking for alternatives found that the bond market too thin to absorb

demand which eventually led to flight of capital. If external finances flow in through non-banking

channels, there is an extra benefit to the economy, namely, capital inflows are less heavily

dependent on the banking system. An important legacy of the Asian financial crisis will be expansion

of the role of stock and bond markets as funding vehicles for corporate fund-raisers. Development

of bond and money market would thus help dissipate the risk which was burdened almost entirely

with banking system in the Asian nations.

Table 11 Gross Domestic Savings, % of GDP

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Average

Thailand 32.8 35.1 34.3 34.9 34.7 34 33.7 32.8 33.2 30.6 33.61

Malaysia 30.5 29.3 31.7 34.7 35.1 33.9 37 37 39.8 38.2 34.72

Indonesia 28.1 20.1 21.4 29 29.9 28.1 27.8 29 22.4 13.2 24.9

S Korea 36.8 37.2 36.3 36.2 36.3 36.2 35 34.9 37.2 35.1 36.12

Philippines 18.3 18.6 19.1 18.5 22.1 19 19.9 21.4 23.5 20.7 20.11

USA 15.1 15.4 14.6 14.4 15.6 16.4 17.3 18.4 18.6 18 16.38

5.3International lender-of-last-resortMost of the emerging economies are plagued with weak financial sector, high proportion of debt in

foreign currency with a weak record of controlling inflation. Asian economies for that matter were


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no exception. There are tendencies for debt contracts of short duration and any expansionary

monetary policy is likely to cause high inflation. The direct result of a high inflation would be to

further weaken the domestic currency and consequently further worsening of balance sheets of

indebted firms and banks. As a result of these factors a central bank in emerging economy is likely to

have limited capabilities in pursuing monetary expansion for recovery in the aftermath of financial

crisis which is the policy prescription for restarting a collapsed financial sector. These arguments

suggest that in order to have a speedy recovery from the crisis foreign assistance can be highly

effective. This is because any foreign assistance does not lead to inflation troubles unlike domestic

liquidity growth. Many economists have thus reasoned that an international lender of last resort for

emerging economy can limit severity and spread of such financial crises. However It must be kept in

mind that this institution must be employed only in extra ordinary situation to limit the tradeoff

with creating moral hazard. To achieve this stronger supervisory and regulatory system forfinancial sector will be required.


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Source of Data in report

1. All data presented in this report is sourced from the World Bank databank website--

http://databank.worldbank.org/Data/Views/VariableSelection/SelectVariables.aspx?source=Wo

rld%20Development%20Indicators%20and%20Global%20Development%20Finance2. Some Charts and figures have been sourced from the papers mentioned in references due their

unavailability in public domain.

References

1. Wade, R. (1998). The Asian debt-and-development crisis of 1997-?: Causes and consequences.

World Development, 26(8), 1535-1553.

2. Chowdhry, B., & Goyal, A. (2000). Understanding the financial crisis in Asia. Pacific-Basin Finance

Journal, 8(2), 135-152.

3. Corsetti, G., Pesenti, P., & Roubini, N. (1998). Paper tigers? A model of the Asian crisis (No.

w6783). National Bureau of Economic Research.

4. Boorman, J., Lane, T., Schulze-Ghattas, M., Bulir, A., Ghosh, A. R., Hamann, J., ... & Phillips, S.

(2000, December). Managing financial crises: the experience in East Asia. In Carnegie-Rochester

Conference Series on Public Policy(Vol. 53, No. 1, pp. 1-67). North-Holland.

5. Bacha, O. I. (2004). Lessons from East Asia's crisis and recovery.Asia Pacific Development

Journal, 11(2), 81-102.

6. Radelet, S., & Sachs, J. D. (2000). The onset of the East Asian financial crisis. In Currency crises

(pp. 105-162). University of Chicago Press.

7. Das, D. K. (2000, December). Asian crisis: distilling critical lessons. United Nations Conference on

Trade and Development.

8. Karunatilleka, E. (1999). The Asian economic crisis. House of Commons Research Paper, 99, 14.

9. Chowdhury, A. (1999). The Asian currency crisis: origins, lessons, and future outlook.

10.Woo, W. T. (2003). Lessons from the Asian Financial Crisis, and the Prospects for Resuming High

Growth. Exchange Rate Regimes and Macroeconomic Stability, 9.

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Study of Asian Financial Crisis 1997

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