Major attributes of the 1997–1998 East Asia crisis

Th ailand was the fi rst victim of the crisis. According to Fischer [1998] Th ailand had been confi dentially warned by the International Monetary Fund about the threat of the currency crisis (Section 3.1). Other countries from the region also received IMF reports indicating the weakness of their fi nancial systems.³ Th e East Asian countries that signifi cantly suff ered from the crisis ran diversifi ed foreign investment policies [Guitian 1998]. Th ailand used to pursue the most aggressive policy of foreign investor acquisition. It introduced tax incentives for foreign investors and created a fi nancial institution, the Bangkok International Banking Facility, the aim of which was to enhance the absorption of foreign capital. By contrast, South Korea and Indonesia followed a cautious policy of capital fl ow liberalization.

2 Th ese were the devaluation of the renminbi and yen, and decline in semiconductor in-ternational prices.

3 Countries from the region, such as Taiwan or Singapore, experienced smaller fl uctua-tions in exchange rate and share price.

Table 3.2. Banking crises in selected East Asian economies in 1981–1988

Country Period Total fi scal cost of

rescue (% of GDP)

Bad loans as per cent of total loans

Malaysia 1985–1988 5 33

Philippines 1981–1987 3–4 –

Th ailand 1983–1987 1 15

Source: [WEO 1998, p. 78].

In fact both a currency crisis and a systemic banking and fi nancial crisis took place in these East Asian countries (see Section 3.1). Usually, the notion of a currency crisis is used to describe a situation resulting from a speculative at-tack on the exchange rate, in which the currency drops in value or is subject to sudden depreciation and/or the authorities are forced to take out loans (mostly from the International Monetary Fund), and/or the authorities must drastically raise interest rates.⁴ Th e notion of a systemic fi nancial crisis describes a situa-tion in which the funcsitua-tioning of the whole fi nancial intermediasitua-tion system is disrupted and this disruption is then transmitted to the real sector. East Asian economies were also hit by a banking crisis (Section 3.1.4). Th is was manifest-ed by the liquidation of a considerable number of banks and the reinforcement of supervision over these remaining, as well as the creation of a technical and fi nancial support facility.

Th e East Asian currency crisis enforced severe adjustments in exchange rates.

Th eir extent is shown in Table 3.3. Th e data in Table 3.3 demonstrates that the currencies of EastAsian countries underwent signifi cant real depreciation of

their currencies which triggered real sphere adjustments resulting in a balance of payments surplus. Th e biggest GDP drops occurred in Indonesia, Th ailand and Malaysia.⁵ In February 1998 stock exchange indices in the East Asian countries undergoing the crisis dropped on average by 50% in comparison with the high-est level in 1996–1997.

Before the crisis, the countries analysed here had not only recorded a large infl ow of direct investment, portfolio investment and loans, but had also become signifi cant importers of investment and consumer goods from Japan and other OECD countries. Currency depreciation and eff ective domestic demand decline were the reasons for the abrupt drop in imports [Adams 1998]. Before the crisis,

4 See: [World Economic Outlook 1998, p. 74ff ].

5 See: [Th e Economist, October 15, 1998, pp. 14–15].

Table 3.3. Current accounts and real eff ective exchange rates in East Asian countries in 1997–1998

Country Current account balance in 1996 (% of GDP)

Real eff ectives exchange rates 1997.06–1998.03 (minus means depreciation)

Indonesia – 3.4 – 61.9

Malaysia – 6.3 – 22.4

Philippines – 4.5 – 21.4

Th ailand – 7.9 – 25.3

Source: [WEO 1998 May; Litan 1998].

Asian countries were the main recipients of foreign capital infl ows outside de-veloped countries. Th eir share in total net capital fl ows reached the highest lev-els in 1995 and 1996 (48% and 42% respectively). Change in capital fl ow growth was particularly big in 1995. Investors opening their positions in East Asia were guided by the criteria of speedy economic development, growing export poten-tial and their international economic competitiveness. However, as the situation evolved, their assessments, especially those regarding microeconomic aspects, turned out to be inaccurate. Ratings agencies were to a large extent accountable for those incorrect evaluations, as they were not capable of providing adequate and timely assessments neither of national risks, nor of the quality of information published by the local real sector and fi nancial sector institutions.

Foreign short-term investments proved to be highly changeable, while foreign direct investments were fairly stable. Japanese banks and international investment funds were the main source of capital for East Asian countries. Th is was why the East Asian crisis fi rstly hit Japanese fi nancial institutions and international in-vestment funds. Th e negative eff ects could be felt to a lesser extent in European

Figure 3.1. Patterns of intra-East Asian trade by industry in 1996–2000 Source: [Fukao, Ishido & Ito 2003, p. 42]

Light industry Agriculture

Others Transportation machinery Food and beverages Mining

Textiles Basic metals

Wood and paper

Pottery products Chemicals

General and precision machinery

Electrical machinery

HIIT, VIIT – horizontal and vertical intra-industry trade respectively OWT – one-way trade (inter-industry trade)

OWT

VIIT HIIT

banks as well. Th e East Asian countries discussed above were mainly intercon-nected by standard foreign trade (Figure 3.1); their fi nancial links did not play a major role. Th ey were attracted by foreign direct investments (FDI) (Figure 3.1) directed at their tradable sector. Due to a high structural similarity and exchange rate, as well as trade policies, they were engaged in competition in the traditional inter-industry trade (Figure 3.1).

Th e fi nancial collapse in East Asian countries did not have the typical features of a currency crisis. Th e fi rst phase of the currency crisis, in particular in the cases of Th ailand and Indonesia, was intensifi ed by erroneous economic policy deci-sions, including new restrictions imposed on foreign investments and the defence of the exchange rate with foreign loans.

When studying these East Asian countries, apart from their high foreign trade exposure, one particularly signifi cant feature was the lack of typical, fundamen-tal macroeconomic sources of the crisis. In the case of East Asia, the sudden rise in fi nancial assets prices and real estate, which preceded the crisis, was the main indicator of internal disequilibrium. Th e substantial defi cit on the current ac-count (Table 3.2) was a manifestation of their external disequilibrium. It did not result, however, from indebtedness of the public sector but from the ever-grow-ing indebtedness of the private sector. Large-scale investments were made in the manufacturing sector. Loan fi nanced capacity growth (in particular the automo-tive, chemical and electronic industries) was based on the assumption that the high rate of export growth could be maintained. Th is resulted in overinvestment.

However, the most signifi cant sources underlying the crisis could be found in the institutional environment and in the functioning of the fi nancial intermedia-tion sector. It was poorly prepared (both in terms of capital and regulaintermedia-tions) to service the high domestic credit demand. East Asian banks did not adequately use either the credit or the currency risk assessment methods. Th e banking sec-tor was insuffi ciently supervised and regulated, which in turn led to moral haz-ard.⁶ Moral hazard, in the particular case of the East Asian countries and their fi nancial intermediation sector, can be interpreted as a biased asset allocation that resulted from investor assumption (implicit or explicit) that the investment was protected. Th is resulted in lower incentives to monitor fi nancial institutions and in an acceptance of higher investment risk.

Th e infl uence of this mechanism can particularly be observed in the experi-ence of Th ailand’s Finance Companies (FC) – nonbank fi nancial intermediaries [Krugman 1998]. Th ese intermediaries gathered some short-term deposits from the domestic market, but most came from off shore locations. Th e FCs based on

6 In the case of East Asia one can talk about two dimensions of moral hazard: local, ac-knowledging that investments are “insured” by the (national) authorities in one way or an-other, and international. Th e latter results from the mere existence of the IMF, its stabilisation functions and bail-out facilities.

such liabilities extended loans and long-term credit, including real estate loans.

Due to the political interconnectedness between the fi nancial sector and the po-litical authorities and the previously mentioned unclear corporate governance structures, both domestic and foreign investors implicitly assumed that the FCs deposits were safe and sound. Th is conviction of the market participants resulted in lower incentives to monitor risk thoroughly. A similar mechanism was also present in other countries in the region and it concerned both banks and real sector institutions that acquired their loans abroad to avoid high domestic inter-est rates.⁷ Th eir level resulted mostly from the credit demand which grew much faster than domestic savings supply. Consequently this also explained the high dependency on external sources of capital.

Th e combination of weak banking supervision, vague ownership structures of nonbank fi nancial intermediaries, low standards of fi nancial reporting and no requirement for independent balance sheet and fi nancial statement auditing by external auditors made it diffi cult or even impossible to eff ectively assess fi rst the risk and then the scale of the crisis. For example, in South Korea, 11% of the credit and loan portfolio was in an irregular situation – this amounted to about 13% of GDP.⁸ It became clear that the real sector in East Asian countries was de-veloping rapidly without its own suffi ciently large capital base. It was dominated by family-run businesses with no tendency or tradition of sharing data or issuing shares. Such companies preferred to acquire capital from bank loans rather than from marketable debt issue. Step by step the fi nancial intermediation sector situa-tion deteriorated unveiling both the low quality of their loan and credit portfolios and overinvestment in the manufacturing and real estate sectors. Th e slump that followed in the regional economies induced high social costs (increase in unem-ployment, loss of savings and a dramatic drop in local currency exchange rates).