Yuen Pak Man & Wee Liang En
Hwa Chong Institution

The Asian Financial Crisis 10 years on:
What has Changed and What have we Learnt?

Summary

Ten years on, Asian economies have apparently rebounded from the devastating impacts of the 1997 Asian Financial Crisis. However, recent volatility in Asian markets suggests that the threat of crisis has not fully receded from the horizon and highlights the need to examine progress made by Asian economies thus far.

In view of this, this essay first reconciles opposing views on the causes of the crisis and argues that while investor panic did trigger the crisis, it was precipitated by weak macroeconomic fundamentals that exposed Asian economies to speculative attacks and contagion effects.

This essay proceeds to outline the progress made by Asian economies in applying lessons learnt: specifically, in terms of crisis prevention, management and resolution.Generally, Asian economies are better placed to prevent similar crises with measured financial liberalization and prudent financial supervision. Even if a crisis were to occur, they are well-posed to limit its impact and handle the aftermath. Hence, in the short run, a recurrence of the 1997 crisis is unlikely; strong fundamentals, buoyed by strong export growth, would prevent a sudden crash. However, in the long run, a reversal of this situation may be possible. Various scenarios could cause a slowdown in the global economy, possibly derailing Asian growth.

Lastly, contrary to popular perception, this essay argues that significant differences between 1997 and today mean that crisis management is fraught with greater difficulty; measures applied in 1997 may no longer be feasible, especially with increased volatility in the global financial environment. Little noticed, too, is that Asian countries have placed less emphasis on building up social safety nets; hence, the social aftermath may be more significant and prolonged.

1. Introduction

Plus ça change. Indeed, on December 19th,2006, Thailand and the baht once again made headlines as the Bangkok stock market crashed 15%, dragging down regional bourses as investors relived nightmares of the financial contagion that swept Asia in 1997.

Apart from that day of déjà vu, though, nothing worse happened: markets shrugged off their losses the next day, and talk of crisis seemed remote once more. However, such incidents of volatility provide the impetus for a reopening of the books on the tenth anniversary of the Asian crisis. Can a consensus on the causes of the crisis be reached? What has changed since then in the economic fundamentals of the region, and what lessons have policymakers learnt? Most importantly, can such a crisis ever happen again?

2. Causes of the 1997 Asian Crisis: Defective Asian model or a mere financial panic?

To address those questions, we must first look at the causes of the 1997 crisis.

Much of the academic discourse on the causes of the crisis has centered on whether it was caused by macroeconomic factors or by investor panic. It is necessary to determine which cause is more dominant, as the two have vastly different policy implications. The former would warrant macroeconomic reforms, while the latter would obviate the need for reform.

2.1.1. Shaky macroeconomic fundamentals

One school of thought focuses on economic fundamentals and asserts thatthe crisis can be attributed to a defective Asian model of development. Although “first-generation” crisis models[1]suggested that macroeconomic fundamentals then were largely sound, there were several indicators of increasing vulnerability by the mid-1990s: misaligned exchange rates, high interest rates, large current account deficits[2] and excessive borrowing from abroad. By mid-1997, total external indebtedness had reached extremely unhealthy proportions[3].

In addition to those external factors, a number of internal weaknesses were equally important: inadequate supervision, crony capitalism, and excessive misallocation of investments. The glut of capital led to widespread misallocation of capital into speculative enterprises. This was worsened by crony capitalism. From Korean chaebols to banks in Indonesia, investments were made not via arms-length transactions but through patronage networks. Rent-seeking behavior[4] contributed to the fragility of the financial system.

2.1.2. Boom and bust-financial panic

The alternative viewasserts that macroeconomic and financial fundamentals were sound, and highlights investor panic as a primary cause. Due to sudden investor panic, massive capital flight occurred[5]as speculative attacks drove currencies down, with disastrous consequences for lenders and their over-leveraged client firms. However, this theory still fails to explain why the Asian Financial Crisis occurred at that specific point in time.
2.2. Reconciling the two schools of thought

A better picture can be obtained of the Asian crisis’ causes by reconciling the two aforementioned points of view. Investor confidence is to some extent endogenous to perceptions of fundamentals; by mid-1997, a financial panic was far more likely for three reasons.

Firstly, the increasingly close integration with world financial markets, coupled with the pegged exchange rate, greatly increased the central banks’ vulnerability to runs. In an open economy, the government cannot easily inject liquidity to prevent losses to depositors; the injection of liquidity can destabilize the exchange rate and cause a run on the domestic currency. Secondly, much of the excessive foreign borrowing mentioned earlier comprised short-term debt; borrowers were thus increasingly dependent on the creditors’ willingness to roll over short-term liabilities. Thirdly, the ratio of short-term foreign borrowing to official foreign exchange reserves increased beyond 100% for the Philippines, Korea, Indonesia and Thailand by 1995. This portended a possible crisis in the event of any uncertainty, since frantic creditors were likely to rush to demand repayment when they knew that foreign exchange was insufficient to repay everyone.

Hence,massive capital flight exacerbated by investor panic triggered the crisis. However, its underlying cause was weak macroeconomic fundamentals that left many economies in the region vulnerable to the sudden withdrawal of capital that devastated lenders and their over-leveraged clients.

3. What Has Changed and What We Have Learnt: Progress of Asian Economies 10 Years On

Since 1997, to what extent have countries learnt and applied the lessons from the crisis? How much progress has been made in reforming the economic fundamentals of the region to guard against a similar crisis? We can chart progress made in three key areas: the prevention of similar crises, the management of crises should they occur, and the resolution of these crises.

3.1. Progress Made: Crisis Prevention

3.1.1. Cautious Financial Liberalisation in Today’s Emerging Economies

In the case of crisis prevention, one of the key lessons of the 1997 crisis was that financial liberalization, especially in developing countries, should proceed in a measured and sequential manner. In their hasty capital account liberalization, many countriespossessed weaknesses in their financial systems that were then exposed by the crisis. Thus, before domestic financial systems are opened up, potential problems (such as high NPL levels, undercapitalized banks and weak regulatory standards) should be addressed to avoid precipitating a crisis.

Ten years on, while continuing to encourage financial liberalization, many emerging Asian economies have strengthened their domestic financial systems. For instance, in 1999, Singapore’s five-year plan to liberalize the banking system emphasized the improvement of corporate governance to ensure resilience and stability. Vietnam, which entered the WTO early this year, has also embarked on a comprehensive six-pronged reform programme[6] to strengthen domestic banks by 2010.
Most Asian countries were moving towards financial liberalization even before 1997. However, China remains an example of a significant emerging Asian economy that has yet to achieve full financial liberalization. Indeed, China emerged from the 1997 crisis largely unscathed because its capital account had not been fully opened. Currently, China is liberalizing its capital account in a sequential and prudent manner, and has been strengthening its fragile domestic banking system to prevent the precipitation of a crisis resulting from foreign competition.

3.1.2. More Prudent Financial Supervision

Once capital accounts have been liberalized, another lesson learnt is that capital inflows should be cautiously managed.Developing economies should avoid chalking up large deficits funded by short-term, unhedged flows of external capital, and instead seek to attract foreign direct investment. Contrary to neoclassical economics, capital controls, when imposed selectively for specific periods of time, may prevent the development of crises[7].It cannot be assumed that high export growth automatically ensures that debt can be serviced, as export growth may suddenly stall[8]. This is particularly relevant for East Asian economies, whose growth today still tends to be export-driven.

Ten years on, Asian countries have avoided the chalking up of the large deficits that were common in the region pre-crisis. With healthy current account surpluses[9], large reserves, and a reduction of corporate-sector debt to pre-crisis levels[10], Asian countries are better prepared for a sudden flight of capital should such an event occur.Furthermore, Asian countries are depending less on portfolio inflows and more on FDI[11], decreasing the potential impact of capital flight.

On a national level, the lesson learnt was that greater supervision is necessary to prevent the accumulation of large deficits. Governments should exercise a disciplined fiscal policy and utilize regulatory frameworks to prevent lenders from accumulating large asset-liability mismatches.

Indeed, capital adequacy ratios are rising across Asia, mostly well above the 8% international minimum.Non-performing loans have also been reduced in most countries; the ratio of NPLs to total loans, which exceeded 25% in Korea and Malaysia and 40% in Indonesia and Thailandin 2000, stands at less than 10% today. This reflects better risk management and regulation.

On a regional and international level, the 1997 crisis revealed the need for various cooperative frameworks to assist economic surveillance by encouraging countries within the grouping to quickly adopt better macroeconomic policies.

Over the past decade, economic surveillance has increased, with forums such as ASEAN+3 established in the East Asian region to encourage regional policy dialogue and help members implement better macroeconomic policies[12]. Compared with 1997, when few such arrangements existed, such a development represents a step forward for improving crisis prevention via early detection.

3.1.3.Developing Competitive Financial Markets

The 1997 crisis made countries realize the importance of developing competitive financial markets. In pre-crisis Asia, a distinctive characteristic was the region’s stunted capital markets[13] that led to overdependence on the banking sector. Over-reliance on banks in turn led to high levels of leverage and inefficient use of capital[14]. Thus, developing bond and equity markets in the region might allow better capital allocation with an appropriate consideration of risk.

Ten years on, the setting up of an Asian Bond Market Initiative (ABMI) in December 2002 has facilitated the growth of East Asian local currency bond markets. Indeed, East Asian bond markets have continued to expand strongly[15], which would spur development of competitive financial markets and reduce risky lending practices. With the development of local bond markets in various countries, the challenge now is to harmonize various markets into an integrated whole.

3.1.4. Exchange rate stabilization

The 1997 crisis also underscored the importance of sound exchange rate surveillance.Since then, most countries affected by the crisis have made notable progress in the implementation of corrective policies and the stabilization of exchange rates. In particular, four of the countries most badly impacted by the crisis[16] have all moved towards operating flexible exchange rate regimes that are carefully complemented by inflation-targeting frameworks. The IMF has also significantly improved the effectiveness of its exchange rate surveillance scheme[17].

3.2. Progress Made: Crisis Management

3.2.1. Ensuring Timely Access to External Liquidity

If a crisis does occur, however, the next step is to limit its impact: to quickly restore market confidence and prevent the contagion that was so evident in 1997. Here, the main lesson wasto ensure that in times of crisis, countries have timely access to sufficient external liquidity to stave off collapse. The provider of this liquidity has traditionally been the IMF; what the Asian crisis demonstrated, however, is that official resources may be limited given the magnitude of the crisis, and the cooperation of private creditors (“bailing-in”) may be necessary in negotiating restructuring of external debt, as was the case in Korea[18].

Since 1997, several mechanisms have been set up, post-crisis, to facilitate the provision of timely and sufficient liquidity. The IMF, for instance, set up a Supplementary Reserve Facility (SRF)[19] that permitted the lending of large sums without any access limit. On a regional level, the East Asian region has developed the Chiang Mai Initiative[20], a network of currency swap arrangements that can support a member currency in a crisis situation.

3.2.2. Reforming International Institutions

While such a bailout needs to be coordinated at the regional and international level, countries need to play their part too by making appropriate adjustments to their fiscal policies[21].In formulating those adjustments, the Asian crisis suggests that there may be no one-size fits all approach. Thus, another key lesson from the Asian crisis is that the IMF cannot continue applying uniform reform strategies to crisis-hit countries. A main criticism of the IMF was that its routine remedies of interest rate hikes, combined with tight monetary and fiscal policies, exacerbated the Asian financial collapse.[22]Alternatively, Asian countries could consider reducing their reliance on international institutions, and instead look towards the creation of an Asian Regional Fund, which may allow more timely and sensitive responses to their needs. For example, it can serve as a lender of last resort for regional economies.

Since then, the IMF has moved away from universal policy prescriptions and instead shaped its adjustment programmes according to individual country characteristics. Local authorities now have a greater voice in determining the specifics of their countries’ IMF programmes; IMF reform is also giving Asian countries more say in IMF policy.

3.3. Progress Made: Crisis Resolution

3.3.1. Establishment of Procedures to Restore Financial/Corporate Sectors

Finally, the aftermath of crises has to be cleared up swiftly; 1997 caused large-scale corporate and financial insolvency.Thus, to allow quick recovery, the key lesson was that procedures must be quickly initiated to restore healthy financial and corporate sectors.Banks need to be recapitalized or consolidated, while corporate debt needs to be restructured; tax relief can also be provided to improve cash flow. For firms that cannot be restructured, efficient insolvency procedures need to be established.

Ten years on, recapitalisation and consolidation efforts have resulted in a cleanup of banking sectors in many regional economies. While more remains to be done, bankruptcy procedures have generally been streamlined and made less onerous, to allow swift restructuring of corporate sectors in case of crisis.

3.3.2. Alleviating the Political and Social Impact

Another key lesson was that countries need to be prepared to deal with the social aftermath: problems quickly exposed by economic crisis (poverty, unemployment and a loss of political stability)[23]. This was especially so in the Asian crisis, where most countries had deficient or even non-existent social safety nets[24], exacerbating the crisis’ impact.Multilateral development banks, in this casethe Asian Development Bank (ADB) and the World Bank, should thus help crisis-affected countries finance policies designed to tackle these social problems[25]. However, having safety nets in place before a crisis would be more helpful, as the lag in theirimplementation during the Asian crisis meant that their rollout coincided with economic recovery, spurring pro-cyclical demand pressures.

Since then, most Asian countries (including those spared the crisis’ effects in 1997[26])have made progress in implementing new social safety nets. Examples include cash transfers, targeted subsidies[27] and human development programs[28]linked to job retraining. Singapore, in particular, has institutionalised the idea of Workfare, which aids the unemployed but prevents the development of a crutch mentality. Regional cooperation has also helped: the APEC Social Safety Net Capacity Building Networkwas established in 2002 to help APEC members share their experiences in reforming social safety nets.

4. Analysis: Implications for Asia- Possibility of another Crisis?

4.1. Reforms: Not Far Enough, Not Fast Enough