The Asian Crisis: a perspective after ten years

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© 2007 The Author Journal compilation © 2007 Crawford School of Economics and Government, The Australian National University and Blackwell Publishing Asia Pty Ltd.

doi: 10.1111/j.1467-8411.2007.00199.x

Blackwell Publishing AsiaMelbourne, AustraliaAPELAsian-Pacific Economic Literature0818-9935© 2007 Asia Pacific School of Economics and Government, The Australian National University and Blackwell Publishing Asia Pty LtdXXX

ORIGINAL ARTICLES

SHORT TITLE RUNNING HEAD

: CORDEN –

THE ASIAN CRISIS: A PERSPECTIVE AFTER TEN YEARS

ASIAN-PACIFIC ECONOMIC LITERATURE

The Asian Crisis: a perspective after ten years

W. Max Corden

*

Heinz W. Arndt Memorial Lecture, Canberra, 22 March 2007

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My self-imposed task here is limited. I want topresent a simplified overview of the causes ofthe East Asian financial crisis and the mainpolicy actions taken against it. I have not triedto make a grand assessment of causes andpolicies, of how something similar might beavoided, and what policy faults were committed,though there are various hints. Many countrieswere affected by the crisis that burst upon anunsuspecting world in 1997, but here I focusonly on the four principal countries involved,namely, Thailand, Indonesia, Malaysia andKorea. I shall note some special features of thecrisis in each of these countries. Usually thePhilippines is included in the list, but thiscountry was actually affected much less,mainly because it had only recently recoveredfrom an earlier crisis and thus its boom wasmuch smaller. Many other countries wereactually or potentially affected, but I do notdiscuss them.

While there are plenty of references to theInternational Monetary Fund (IMF), I do notdiscuss systematically the role of the IMF inthe East Asian crisis, or make an assessmentof its activities. This is a popular subject onwhich there has been a considerable literatureand strong views are held. It would take a fulllecture to deal with it. I reviewed it all conciselyin Corden (1999) and my views have not changedsince. Recent and valuable assessments are inthe report of the IMF’s Independent EvaluationOffice (2003) and in Ito (2007).

I have drawn extensively on the publicationsof present or former members of the Departmentof Economics in the Research School of Pacificand Asian Studies of the ANU, of which HeinzArndt was head for many years, namely Hill(2000) on Indonesia, Athukorala (2001) onMalaysia and Warr (1999, 2002, 2005) onThailand, as well as Corden (2002) on exchangerate policies and experiences. In addition, Ihave benefited from Lee and Rhee (2007) onKorea, and Siamwalla (2005) on Thailand.

The Boom

In the four countries, Thailand, Indonesia,Malaysia and Korea, there was an investmentboom financed both by local savings and byforeign capital inflow. This was a familiarstory—such booms have happened, evenwhen capital markets are closed to capitalinflow or outflow. But this one was truly inter-national. Significant capital account opening inthe early 1990s in Thailand, Korea and Malaysiaplayed a key role in the story. The explana-tion for the boom was simple: the countries’macroeconomic policies and outcomes werevery favourable when compared with those ofother developing countries; budget deficitswere low and, in some cases, there were sur-pluses; and inflation was low and growthrates were high. These countries were the starsof the developing world.

* University of Melbourne, Australia.

1 This is an expanded version of the H.W. Arndt Memorial Lecture given at The Australian National University on22 March 2007. I am indebted to valuable comments on drafts of this paper from Robert Z. Aliber, Prema-ChandraAthukorala, Stephen Grenville, Hal Hill and Peter Warr.


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© 2007 The AuthorJournal compilation © 2007 Crawford School of Economics and Government, The Australian National University

and Blackwell Publishing Asia Pty Ltd.

In Thailand and Malaysia, new industriesfor exporting manufactures were establishedor further expanded as a result of FDI aswell as local investment financed in Thailand,in part, by foreign borrowing. In Korea, inter-nationally successful conglomerates (

chaebols

)were financed to enable further internationalexpansion. Stock market values rose. Thesecountries indeed looked good. They werepart of the ‘Asian miracle’. I have the impres-sion that much of the investment, especiallyin the early part of the period, was sound.This was probably true, especially in the caseof investment in Thai and Malaysian exportindustries.

As usual, the booms went too far. Therewas ‘irrational exuberance’ not just in thecountries themselves but also in the worldcapital market. In Thailand and Malaysia,where the funds initially went into developingmanufacturing industries, real estate boomsdeveloped and got out of hand. Investmentshifted from manufacturing to construction.In both countries, there was a huge stockmarket boom. All of this was bound to cometo an end. The four countries had been verysuccessful, but they were not perfect. Therewas a lack of transparency in investmentallocation, and excessive political influenceon bank lending.

The various crises earlier in Latin America—other than the 1994–95 Mexican crisis—hadoriginated in excessive borrowing by the publicsector, including parastatal enterprises. Bycontrast, the Mexican crisis was the first post-World War II crisis originating in the privatesector. This East Asian crisis was also a privatesector crisis. Indeed, one reason why the flowof international capital to these countriesaccelerated after 1994 was the rebound fromthe Mexican crisis. For some years Mexico hadbeen the largest recipient of private fundsflowing to ‘emerging markets’.

While inflation was generally low whencompared with Latin America, there was realappreciation with nominal exchange rates moreor less fixed to the US dollar (or movingclosely with it), and domestic prices andwages rising somewhat faster than in the USand other trading partners. In some cases,

notably Thailand and Malaysia, there werelarge current account deficits, this being theway in which capital inflow was transferredinto the economy. These deficits were notreally a separate phenomenon but were a partof the capital inflow story.

During the boom, capital inflow took essen-tially three forms. First, there was FDI, whichwas important in Malaysia, but to a lesserextent in Thailand and Indonesia and restrictedin Korea. Flows of such investment seemed tohave been fairly stable, and not changing inresponse to ‘herd effects’ (investor sentimentmoving

en masse

). Nevertheless, the flowswould in time have surely responded some-what to changes in expectations about exchangerates and investment profitability. Second,there were inflows of portfolio capital intolocal stock markets. This was particularlyimportant in Malaysia. Finally, there wasshort-term borrowing from the world capitalmarket by local banks and other financialintermediaries, and also by corporations, all inthe form of debt-creating instruments. Thelenders were international banks and alsomutual funds, pension funds, and so on. Thedebts were (almost) all denominated in USdollars. Both portfolio capital and short-termborrowing were highly responsive to changesin expectations and lacked the relative stabilityof FDI. It was a feature of the boom that somuch of it was financed by highly mobilecapital in the form of short-term borrowingand, to a somewhat lesser extent, in the formof portfolio capital.

The bust and the trigger

It may be inevitable that a boom comes to anend some time, but not necessarily a suddenend. There could be a ‘soft landing’, with agradual decline in investment and capitalinflow. But the ‘herd effect’ in the internationalcapital market may lead to a sudden end inthe form of a crisis, which would be a ‘hardlanding’. Usually it is not possible to predictwhether there will be a soft or a hard landingand, if the latter, when it will take place. Onecan see the possibility of a crisis but cannot

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predict it. This applied as much to the EastAsian crisis as it does now to a frequentlypredicted ‘dollar crisis’, or indeed a housingcrisis in various countries.

A hard landing usually has to have atrigger of some kind. But the trigger is notthe fundamental cause of a crisis. In thesefour Asian countries, the fundamental causewas the inevitable ending of the investmentboom owing to eventual over-investment,and the financial difficulties that an excessiveboom was causing. In the case of Thailand,the trigger was a combination of domestic andexternal factors that led to a drastic collapsein the growth rate of exports (from over20 per cent a year to about zero) in 1996, andthus to an increase in the current accountdeficit. I shall come back to that later. Thisexport growth collapse led in 1997 to anexchange rate crisis in Thailand, with theThai currency (the

baht

) depreciating from26

baht

to the US dollar to 47

baht

. In the caseof the other three countries, the trigger wasthe

baht

depreciation.Suppose there had not been a sudden and

sharp depreciation of the

baht

, would therestill have been crises in the other three coun-tries? This is a relevant question because it isoften argued that international action is neededto avoid contagion. And when an event inThailand set off crises in Malaysia, Indonesiaand (after some lag) Korea, for example, it isindeed a case of contagion. The answer has tobe that, for fundamental reasons, the booms inthe latter three countries had to come to anend; but if there were no trigger there wouldbe a soft rather than a hard landing, and henceno crisis. Yet it is also possible that, in theabsence of the Thai exchange rate crisis,eventually there would have been some othertrigger.

My general conclusion, at this point, is thatthe fundamental cause of the crisis was thatthere had been investment booms that endedin a period of ‘irrational exuberance’. Bothlenders and borrowers, as well as financialintermediaries, should be blamed for this. Itwas not predictable that the boom wouldend in a crisis, but it was certainly a possibility.The sharp decline in investment caused

recessions in all countries, with a multipliereffect literally multiplying the effect of theinvestment slump as reflected in a decline inconsumption. As shown in Table 1 below,the recessions were deepest in Indonesia andThailand.

Table 1

Real growth rates

(% of GDP)

The international nature of the boom andsubsequent slump clearly depended on theability of capital to move freely, or relativelyfreely, internationally. Thus the liberalisationsof international capital movements that hadtaken place earlier were crucial, especially inallowing contagion to take place. India andChina, which had strict capital controls, didnot have crises. But with regard to the fourcountries on which I focus here, one should bemore precise. For Thailand, a crucial policyfeature was the gradual liberalisation, espe-cially of short-term capital movements, thattook place principally in 1993 (Siamwalla2005). Indonesia had fully liberalised in the1970s, and in practice enforceable controlswere hardly feasible anyway. Malaysia wasvery liberal about FDI and also portfolio capi-tal, but not short-term, debt-creating borrow-ing. I shall come back to this important featurelater. Finally, Korea had controlled and dis-couraged FDI inflow, but had liberalisedshort-term, debt-creating borrowing, leadingto massive short-term, interbank inflows. Itsliberalisation was associated with its member-ship of the OECD.

At this point, let me mention that, aftergiving this lecture, I looked at Kindleberger

Country 1988–95* 1996 1997 1998 1999 2000

Indonesia 7.9 7.8 4.7

−

13.1 0.8 4.9Malaysia 9.4 10.0 7.3

−

7.4 6.1 8.9South Korea 8.1 7.0 4.7

−

6.9 9.5 8.5Thailand 10.0 5.9

−

1.4

−

10.5 4.4 4.8

* Average growth rate.

Source

: Asian Development Bank at <http://www.adb.org>, accessed on 8 May 2007.


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and Aliber (2005) on ‘Manias, Panics andCrashes’. This is the fifth edition of a classic byCharles Kindleberger, first published in 1978.It tells the story of numerous booms thatended in crises. Financial crises, or ‘bubbles’ asthey are addressed, are hardy perennials.The authors list (p. 8) ‘the big ten financialbubbles’, beginning with the Dutch Tulip BulbBubble of 1636, and including the late 1920sstock price bubble which preceded the GreatDepression. One of these ten is the East Asianbubble, which they regard as beginning in1992 and, of course, ending in 1997. This putsthe topic of this lecture in perspective. Onechapter of the book discusses ‘internationalcontagion’, another ‘the domestic lender oflast resort’, and all issues that arise in any dis-cussion of the East Asian crisis are covered.

The exchange rate regime and

exchange rate crises

It may seem surprising that I have hardlyreferred to exchange rates so far, other thanthe brief reference to the Thai

baht

. The EastAsian crisis is often thought of as a currencyor exchange rate crisis. And, it is true that,in Indonesia, Malaysia and Korea, it wastriggered by the depreciation of the

baht

.What then is the relationship between theexchange rate regimes and the investmentbooms and slumps? Before the crisis, threeof the countries had (more or less) fixedexchange rates to the US dollar. The Indonesiantarget zone regime was somewhat (and notvery much) more flexible. The first point isthat, if the exchange rates had floated and ifthe underlying changing expectations aboutinvestment profitability had been the sameas they actually were, then there would stillhave been a boom followed eventually by asoft or a hard landing.

During an investment boom, nominalexchange rates would have appreciated, sothere would have been less inflation than thereactually was with a fixed exchange rate, butthere would still have been current accountdeficits (real appreciation might have beensomewhat greater, and this might have

moderated the boom). When investment eventu-ally declined, there would have been nominaldepreciation, possibly very sharp—that is, ahard landing. After a lag, the depreciationwould probably have stimulated export andimport-competing sectors, and thus wouldhave moderated, or even ended, the recessioncaused by the investment slump. One mightcompare this with what actually happened.The various crises ended the fixed rateregimes, and this was followed by substantial(in the case of Indonesia, vast) depreciations,which eventually stimulated exports. With afloating rate initially, this stimulus to exportswould have happened earlier.

I have focused on the underlying funda-mentals, namely the investment booms andslumps, which were somewhat similar in allfour countries. How did the exchange ratecrises fit in? Consider first Thailand. The assetprice bubble burst already in 1994 and theterms of trade worsened in 1996, so thatthere was a drastic decline in the growthrate of exports. As Warr (2005) points out, anadditional reason for the decline in exports,especially of labour-intensive goods (garmentsand shoes), was the steady rise in real wagesdue to the gradual ending of the availablepool of surplus labour from rural Thailand.The current account deficit sharply increased.With the use of foreign exchange reservesand foreign borrowing in the forward marketby the central bank, the exchange rate waskept fixed. With the bursting of the assetprice bubble, banks got into trouble, andthe central bank then engaged in monetaryexpansion to rescue the banks. Such expan-sion reduced the foreign exchange reservesfurther. By 1996, it was clear that the investmentboom was at an end. The ‘fundamentals’ haddeteriorated. Finally, in 1997, speculation onthe exchange rate forced an end to the fixedexchange rate regime. Short-term capital flowssharply reversed.

Thus the currency crisis clearly followedthe investment and banking crises after a lagof one year or more. Here it should be notedthat, as Warr (2002) has pointed out, Thailandhad become very vulnerable to a currencycrisis because of the growing stock of very

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volatile short-term debt relative to the stockof reserves. Short-term debt had been accumu-lating since 1993, when the gradual openingof the capital account was capped with theestablishment of the Bangkok InternationalBanking Facility.

The story was much the same for Korea.There was clear evidence of a financial crisis,or at least difficulties, well before the currencycrisis (Krueger and Yoo 2001). There had beenexcessive lending to unsound borrowers;the terms of trade deteriorated in 1996; andconfidence was shaken by evidence of pro-blems in the banking system. Only late in 1997was there a currency crisis forcing abandonmentof the fixed exchange rate regime.

In the case of Malaysia, well before thecurrency crisis, the stock market had risento excessive heights and there were signsof banking problems. Again, in the case ofIndonesia, the fundamental problems weremuch the same. Because of the lack of datathen, however, there was less awareness ofan international borrowing binge and thusof a likely problem. In this case, the ex-change rate crisis—triggered by the

baht

depreciation—came first, and the financialcrisis followed.

The currency mismatch—unhedged

foreign borrowing

I now come to a very important aspect ofthe whole story, which does not apply toMalaysia but does apply to the other threecountries. Borrowing in the form of debt, pri-marily from international banks, was short-term and was generally denominated in USdollars. This borrowing was not hedgedagainst the possibility of a devaluation ordepreciation of the domestic currency. Whythis was so is a subject for discussion, butI will temporarily pass over this question.The consequence of such lack of hedging wasthat, when the domestic currency depreciatedsharply—hugely in the case of the Indonesian

rupiah

—big losses were incurred by domesticbanks that had acquired international debtsin US dollars and had on-lent domestically in

local currency. There was a ‘currency mismatch’which created balance sheet problems. Insome cases, particularly in Indonesia butalso in Korea, local non-financial corporationsborrowed abroad from international banksin US dollars (without the intermediation oflocal banks) and so also acquired the currencyrisk. Sometimes local banks lent in US dollarsto local firms, so that the firms then carriedthe currency risk and the banks acquired acredit risk.

In all these cases, balance sheets of banksand corporations were severely affected by theexchange rate depreciations that resulted fromthe ending of the investment boom. In fact,many banks and corporations were bankrupted.Thus the currency crisis greatly added tothe financial crisis because of the currencymismatch problem.

I suggested earlier that the exchange rateregime may not have made much difference tothe fundamentals—even with a floating ratethere would have been an investment boomthat was followed eventually by a slump.Whether the exchange rate was initially fixedand then depreciated in a currency crisis, orwhether it had floated and simply depreciatedwithin the floating rate regime once capitalinflow declined, the basic story would havebeen much the same. But now there is anotherfactor to take into account, namely, the balancesheet effects of unhedged foreign borrowingdenominated in foreign currency.

I come now to the reason why there was afailure to hedge against the consequencesof the currency mismatch. In a floating rateregime, the demand for hedging is likely todevelop and an appropriate market for hedgingwill emerge. The experience of variable exchangerate values makes a desire to hedge likely,and perhaps even inevitable (as in Australia).By contrast, in the fixed rate regimes theneed for hedging was not perceived becausea breakdown in the regimes was thoughthighly improbable. But, when the regimes didbreak down, the currency mismatch causedbalance sheet problems that had not beenhedged against, and which thus damagedbanks, other financial intermediaries, andcorporations that had borrowed in US dollars


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but expected to receive income in domesticcurrency.

2

The recessions

In all four countries, there were deep recessionsin 1998. One can break down the several ele-ments that caused the decline in demand andthus the recessions. First, there was the declinein investment that started off the crisis. Second,there was the financial crisis caused by theexcessive domestic lending and by the declinein asset values resulting from the change inexpectations. The difficulties of banks andother financial firms led to a drying up of newcredit. One might say that the boom in thelending had been very unwise, and now thecountry had to deal with the consequences.Third, there was the reduction of privateconsumption resulting from the multipliereffect of the two shocks just mentioned. Finally,there were the consequences on balance sheetsof the currency mismatch that I have justdiscussed—the reduction of credit by domesticbanks and the reduction of spending by cor-porations, both resulting from the adverseeffects of the currency mismatch on theirbalance sheets. The bigger the crisis depreciationof the exchange rate, the bigger this effectwas. Since the Indonesian depreciation washuge, it is not surprising that this adverseeffect of currency mismatch in Indonesia wasalso huge.

The policy responses

There were three possible policy responses, andall were eventually pursued in all four countries.

Moderate the depreciation

The first policy response was to try to moderatethe depreciation by raising the domestic interestrate and by various other measures that wouldrestore the confidence of foreign investors inthe currency and, indeed, also the confidenceof local investors. This was very much thefocus of initial IMF advice or conditionality.The main concern was to minimise the impactof the currency mismatch effect—the less thedepreciation, the less harmful the effects onthe financial sector would be. In addition, itwas thought that fiscal and monetary tightnesswould improve confidence and thus moderatethe depreciations.

The major problem with monetary tight-ness designed to moderate depreciation isthat there is an obvious trade-off. Thehigher the domestic interest rate is, the moredeflationary the effect for those firms thatdepend on domestic credit will be. One doesnot normally raise interest rates in a recession!On the other hand, higher interest rates maysucceed in moderating depreciations, andthis would moderate the adverse effect ofcurrency mismatch for firms. Both aspectshave to be taken into account, and critics ofthe IMF have emphasised the first aspect.There has been much empirical analysis ofthe strength of the second aspect. To whatextent does an increase in the domestic interestrate appreciate the exchange rate? I am notsure that there is a conclusive answer. At thebeginning of the crisis, the IMF emphasisedthe need to moderate depreciations boththrough interest rate policy and, more generally,by restoring confidence; but its emphasischanged as the severity of the recessions becameapparent.

2 It can be argued that hedging was not available because it would require foreigners to take exposure. Hedging will shiftrisk, not eliminate it. That is correct. But one has to explain why foreigners, ever in search of profits, did not get into thisbusiness. They would profit if the event insured against does not happen. If it does happen—that is, if the

rupiah

doesdepreciate—they would have to sell dollars and buy

rupiah

. They thus must be prepared to take exposure. But taking onrisk is the business of (say) hedge funds. I therefore conclude that hedging was potentially available, but there was nodemand. If demand had emerged, supply would have emerged as a result. In the case of Indonesia, where the exchangerate was not absolutely fixed, the market only expected moderate exchange rate changes, and hence there was nodemand for hedging. The extreme event that actually happened was thought inconceivable. Ron Duncan has alsopointed out that hedging is very difficult, if not impossible, with fixed-but-adjustable exchange rates because changes inthe rate occur at the whim of governments, so that the market cannot assess the risk. There is no probability distributionupon which it can base a financial derivative.

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Rescue the banks

The second response by the governments orthe central banks was to rescue the privatebanks so as to save the financial system. Bankswere in trouble because of their initial unwiselending in the boom and the subsequentdeclines in asset values. They suffered furtherfrom the balance sheet problems just dis-cussed, and finally from the lack of demandthat caused the recession, also just discussed.Restoring the financial system was importantbecause consumption and investment demandsdepend on the availability of credit. Further-more, the depreciations should stimulateexports—which eventually was indeed animportant source of restored demand for thecountry’s products, but which depended ontrade credit. In the short run a shortage of tradecredit was a serious problem in Indonesia.

Hence, governments bought non-performingloans through asset management companies.They financed these purchases by the issue ofgovernment bonds sold to domestic or foreignbuyers (that is, fiscal policy), by foreign officialloans (including loans from the IMF), or bymoney creation. The last would increase thedepreciation and thus worsen the balance-sheetproblem. In any case, restoring the financialsystem by rescuing banks and other financialintermediaries was an objective in all countries.In the case of bond finance and foreign loanfinance, the costs of unwise or unlucky bor-rowing and lending were, at least to someextent, transferred from private sector borrowersand lenders to the taxpayers of the four crisiscountries.

Writing about the situation in Korea, Leeand Rhee (2007:150) observe that ‘. . . theexpansionary fiscal policy after the crisissuccessfully stimulated the economy andfacilitated the development of financialmarkets . . .’ They also note that the ratio ofsovereign (that is, government) liabilities toGDP increased from less than 6 per cent beforethe crisis to 32 per cent in 2004. Inevitablythis created some moral hazard, though therescues of the private sector were usually notcomplete; pain remained for the rescued. Theessential argument in favour of such rescues

was that the alternative of allowing the marketto work would lead to prolonged recessionand thus would create collateral damage—thelosers would not just be the relevant privatedomestic borrowers and domestic and foreignlenders, but all those citizens who lost theirjobs or suffered drops in incomes as a result ofcontinued recessions, or even a depression.Furthermore, international defaults wouldaffect the reputation of the country as a futureborrower. Perhaps there was a possibilityof moral hazard, but it seems that creditorsand local depositors, rather than local banks,were protected. In addition, there was forcedrestructuring, both of corporations and of banks,especially in Korea (for details, see Bank forInternational Settlements 2000). For Thailand,Siamwalla (2005) analyses in detail the effectsof the crisis on finance companies, commercialbanks, and corporations, and the restructuringand recapitalisation process.

Keynesian demand expansion

The third possible policy response was tocompensate for the decline in investmentdemand and the various other sources of therecession outlined above with a domesticdemand expansion. This was a straightforwardKeynesian policy. It included various increasesin public expenditure (such as food subsidies)designed, for example, to help the poor andthe unemployed. One might also think here ofpublic sector infrastructure investment as atraditional Keynesian counter-cyclical policy,but the difficulty in this case is the inevitablelag in planning and executing such a policy.Deliberate reductions in interest rates wouldalso be part of such a policy.

Incidentally, one could regard the previousapproach of rescuing the financial sector andcorporations as being part of this Keynesianapproach because it would also lead to demandexpansion. But because it creates moral hazard,it is best thought of as being distinct, thoughhaving Keynesian effects.

A switch to this Keynesian demand-expansionfocus (including rescues of the financial sector)did take place in 1998 as the severity of therecessions became apparent, though the


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eventual limits were set by the availability offoreign finance. In 1998, this Keynesian approachseems to have been followed in all countries tosome extent, but most clearly in Korea andin Malaysia. Given the depth of the crisis, Iadvocated it in a lecture in Singapore in August1998 (Corden 1999).

In practice, all three approaches that Ihave discussed here were followed in allfour countries. The first approach—seekingto moderate depreciations by raising domesticinterest rates and tightening fiscal and monetarypolicies to restore confidence—was followedearly in the crisis and was soon abandoned.The second approach—rescuing the banks—was a central feature of public policy rightthrough in all countries. A shift to the thirdKeynesian approach emerged mostly in 1998,when the seriousness of the recessions becameclear. By 1999, exports started increasing as aresult of the real depreciations, and graduallydomestic demand expansions were needed less.

The four countries: some

special aspects

The next step is to look at some special aspectsof each of the four countries.

Thailand

Thailand displayed most clearly the disadvant-ages of a fixed-but-adjustable exchange rateregime (FBAR). The implications of such aregime—the pros and cons—have been analysedfully in Corden (2002). Thailand had a strong,long-standing commitment to an exchangerate fixed to the US dollar, and this helped toexplain its long history of very low inflation.But when they got into difficulties around1996, the Bank of Thailand extended creditto financial institutions, which led to monet-ary expansion and in turn reduced foreignexchange reserves. In addition, the Bankborrowed from the forward market. A Thaifinancial crisis was thus already under waywhen, in 1997, a speculative attack on the

baht

forced the central bank to give up the fixedexchange rate regime and allow the

baht

to float.

This was a familiar story. It reminded oneof the UK’s 1992 crisis when sterling wasforced to leave the European Exchange RateMechanism (ERM). In such cases, a centralbank makes big losses to the benefit of privatespeculators. It is worth noting that Indonesiadid not get into this situation. As pressure onthe

rupiah

mounted, the Indonesian authoritiesquickly gave up their target zone regime andallowed the

rupiah

to float. Here I should mentionthat Indonesia did not have a strictly fixed rateregime before the crisis, but something close toit—a narrow target zone within which the ratefloated, and a central rate that had a modestrate of crawl. This did mean that its exchangerate regime was more flexible as soon as thecrisis broke. Malaysia and Korea also did nothang on to their (more or less) fixed exchangerates for very long. In this respect, Thailandwas special.

Indonesia

Indonesia had the biggest exchange rate andgrowth decline, and the slowest recovery. Whywas this? Its initial economic position appearedto have had fewer problems than the otherthree countries (Hill 2000), though to someextent this was only an ‘appearance’ becauseinadequate data did not reveal problems ofexcessive or unwise investment. But the mainpoint I wish to stress here is that in Indonesiaan economic problem interacted with a potentialpolitical problem. The political problem wasthat of the succession to elderly PresidentSoeharto, and, in addition, his declining abilityto manage the country. Each problem—theeconomic and the political problem—was madeworse by the other. The trigger was a depreci-ation of the Indonesian

rupiah

caused by the

baht

depreciation—a straight case of contagion.Because of the currency mismatch, this causeda balance-sheet problem for banks and cor-porations that had borrowed directly overseasin US dollars. That is a familiar scene—efforts to rescue banks were financed by moneycreation, and this increased the depreciation.Indeed, for a period in early 1998, Indonesialost control of monetary policy, though inflationwas brought under control by late 1998.

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9


The extreme depreciation that came aboutand that created huge currency mismatchproblems was caused by a loss of confidencein President Soeharto’s government. Onereason was that the IMF—which had beenbrought in quickly to support the exchangerate—set conditions that were unacceptableto him; conditions that would weaken theinfluence of and gains to the Soeharto family.Basically, Soeharto rejected IMF conditions. Inaddition, there was uncertainty about his healthand the succession. The Chinese businessminority lost confidence in their security,which added to the flight of capital.

Thus one can say that the economic problem—triggered by the Thai depreciation—in turntriggered a political crisis, the potential forwhich already existed, and this political crisisin turn worsened the economic problemthrough increasing the depreciation of the

rupiah

and thus the currency mismatch effecton banks and corporations. This argumentsounds complicated, but is actually over-simplified. It is an attempt to explain why theeffects of the East Asian crisis have been muchmore severe in Indonesia than in the otherthree countries even though Indonesia’s initialmacroeconomic situation appeared quite good.

Korea

There are, of course, many special featuresof Korea, which is by far the largest of thefour Asian crisis economies. Here I will justnote two.

The first is that more assistance wasgranted to Korea by the IMF and the US thanto the other countries. The Korean crisis wasseen as a bigger threat to the world financialsystem because of the size of the economyand especially the very high short-term debtsincurred by Korea’s corporate sector and theirassociated banks (the

chaebols

).The first financing package, arranged by

the IMF at the end of 1997, was primarilyconcerned to deal with the major drain on thecapital account coming from bank debt repay-ments (resulting particularly from offshoreborrowing by overseas branches of Koreanbanks). The IMF’s own funds were quite modest

(partly because the Korean IMF quota relativeto its GDP is quite small), and so a crucialelement of the package consisted of promisesfrom various bilateral sources, notably the US,but also from other developed countries. Butthis was not sufficient—or sufficiently certain—to restore market confidence, so Korea’s for-eign exchange reserves dwindled rapidly. Thisled to an important and successful devel-opment, namely the ‘coordinated roll-over’(Independent Evaluation Office 2003:114–5).

Under pressure from the governments ofcreditor countries, the creditor banks of the var-ious countries agreed to ‘roll-over’, that is, tomaintain their existing credit lines (that is, notto require repayments of short-term credits)and also agreed to extension of maturitiesof their claims on Korean banks. This wassuccessful in restoring liquidity and henceconfidence. All the extended loans wereeventually repaid by the original Koreanborrowers. In fact, 90 per cent was repaid byApril 2000, though only 63 per cent wasscheduled to mature by that date (IndependentEvaluation Office 2003).

The other special feature of Korea was thatits recovery was faster than that of the othercountries. Already by 1999 the Korea growthrate was 9.5 per cent. By contrast, the Thaigrowth rate in 1999 was 4.4 per cent. Thisrapid recovery of Korea was explained by theswitch to expansionary monetary and fiscalpolicies in the middle of 1998. According toLee and Rhee (2007), this was made possibleby the structural changes that had beenbrought about very quickly and effectively in1998. There were many public credit guaranteeprograms. In their view (p. 152), ‘counter-cyclicalfiscal policy can be quite effective when com-bined with financial restructuring’. The IMF’sIndependent Evaluation Office (2003:109) notedthat ‘public funds totalling over 20 per cent ofGDP would eventually be committed to cleaningup the banking sector’. It certainly helped thatbefore the crisis Korea had a very low ratio ofpublic debt to GDP (6 per cent).

To conclude discussion of the Korean expe-rience, it would be interesting to make an in-depth study comparing the reactions to the crisisin Thailand with that of Korea. Why did Korea


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have a substantially faster recovery? One likelyfactor was that the proportion of non-performingloans remaining with commercial banks in 1999was far lower in Korea (6.2 per cent) than inThailand (38.6 per cent) (see Bank for Inter-national Settlements 2000). This differencemay reflect the greater impact in Korea of thegovernment-financed asset management com-panies. Another factor may have been thatKorea’s current account deficit as a percentageof GDP was, to start with, much lower thanThailand’s. In 1996, the deficit was 4.4 percent of GDP for Korea and 7.9 per cent forThailand. Finally, there was the financialsupport provided by the US to Korea, com-bined with the US-supported roll-over arrange-ments. This contrasts with the rather modesthelp given by the US and Japan to Thailandand Indonesia.

3

Malaysia

Malaysia is actually a very special case fortwo reasons. There are important lessons to belearnt here.

First of all, Malaysia did not have a currencymismatch problem, and, as a result, none ofthe difficulties that it caused in the other threecountries, especially in Indonesia. I shall cometo the reason for that in a moment. Neverthe-less, Malaysia did still have a crisis triggeredby the Thai depreciation, but the crisis wascaused fundamentally by the inevitable endingof a sky-high investment, stock market andreal estate boom. Thus the ‘fundamentals’were the same as in the other three countries.Financial fragility resulted from unwisedomestic lending. This convinces me that thefundamental factor in all four countries wasthe investment boom and slump.

Coming then to the special feature of Malaysia,it had effective regulations administered bythe central bank that set ceilings on foreigncurrency borrowing or lending. The central bankthus allowed very little accumulation of foreign

currency denominated debt. As a result, thecrisis and depreciation of the Malaysian currencycreated no foreign-debt problem, and thusMalaysia did not need the IMF to rescue it. Ofcourse, banks did borrow domestically on alarge scale because of Malaysia’s high domesticsavings. And there was still very volatile foreigncapital inflow in the form of portfolio flows.When expectations changed suddenly, theseflows reversed and set off the crisis.

It is worth emphasising that the currency-mismatch problem was an important factorin Thailand and Korea, and a major factor inIndonesia, but in Malaysia it was not a factorat all because its central bank did what othercentral banks are often urged to do—namely,control or limit foreign short-term borrowingby domestic banks. Yet, as I have said, Malaysiastill did have a crisis.

The other special feature of Malaysia wasthat, in 1998, its government-imposed controlson short-term capital outflows, in particular onthe repatriation of portfolio capital by non-residents as well as on speculative positionsagainst the currency. After a year these controlswere modified, but they did give more free-dom to fiscal and monetary policies, allowingthe domestic interest rate to fall below the USinterest rate. There is some evidence that thesemeasures allowed the recovery to be some-what greater or earlier than in Thailand. Thecontrols may not have made a big difference,but in the judgement of Athukorala, withwhich I agree, the net effect was beneficial(Athukorala 2001, Corden 2002).

It is clear to me that controls on short-terminternational capital flows, whether inflows oroutflows, should not be ruled out, at least inparticular circumstances. But one has to keepin mind that there are administrative problems.For that reason alone the controls were moresuitable or indeed more feasible for Malaysiathan for Indonesia. Furthermore, the benefitsof free portfolio inflows and outflows mustalso be taken into account.

3 After completing this paper, I became aware of Park and Lee (2002) which systematically compared the post-crisisadjustments of the crisis countries (including the Philippines). The differences manifested themselves in the performanceof investment and export growth. They found that real exchange rate depreciations, expansionary macroeconomicpolicies and favourable global environments were the critical determinants of the post-crisis recovery. IMF financialassistance had no independent impact.

CORDEN —


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Was it a liquidity crisis?

At last, I come to the ‘liquidity versus solvencycrisis’ issue. In a very thorough discussion ofthe East Asian financial crisis, Ito (2007:43)concludes that “in summary, many believethat the Asian crisis was a ‘liquidity crisis’ ratherthan a ‘solvency crisis’ with fundamentalstructural problems”. Ito notes, as evidence,that Korea and Thailand had repaid all theirIMF debts by 2004, and Indonesia had repaidabout half by June 2006 and planned to repaythe rest within a year or so. Park and Lee(2002:315) also concluded earlier that the crisiswas, in large measure, a liquidity crisis causedby investors’ panic: ‘[o]nce the liquidity con-straint was eased as it was during the first halfof 1998, domestic demand has since surgedagain and the crisis countries have been able tomove toward the pre-crisis path of growth.’

It seems to me that it is correct to argue thatfor the countries or, to be precise, the govern-ments, there was an element of a ‘liquiditycrisis’. But it was superimposed on the ‘funda-mentals’ that I have discussed. If more finan-cial resources (that is, more liquidity) had beenavailable, exchange rates might not haveneeded to depreciate so suddenly and severely.Of course, the fundamental factors—the inevit-able ending of the investment booms—didrequire some significant depreciation. But, as Ihave said, these need not have been so suddenand severe. Especially, the temporary and massiveovershooting of the exchange rate depreciationin Indonesia might have been avoided if majorcountries, notably the US and Japan, had beenprepared to provide quickly more back-upresources to the IMF. The IMF itself had verylimited funds available given the size of thequotas of the three countries (Thailand,Indonesia and Korea) that it supported.

It is arguable that the countries had beenreasonably well managed in their macroeco-nomic policies and did not really have solvencyproblems. As in the earlier case of Mexico,no losses were incurred by making emergencyloans to their governments. For this reason,there was also no moral hazard issue for thegovernments. Essentially there was a marketfailure, reflected in inadequate international

liquidity in the short term. The Korean ‘roll-over’coordinated by the IMF was very effective andensured that private lenders played some partin the rescue. Probably such roll-overs wouldhave been harder to arrange in the case ofThailand and Indonesia since the major lenderswere harder to identify.

These remarks concern the governmentsand their central banks. But the story is some-what different with regard to the privateborrowers—especially the banks, but alsocorporations—in the four countries. Here Iwould say that there was indeed a solvencycrisis resolved eventually by the governmentsand central banks. The details varied by country,but it is clear enough to me in the Koreancase that there was a transfer of debts to thegovernment—that is, the taxpayers. The

chaebols

and their banks were not in a position torepay. The non-performing loans that werebought by the government did turn out to beat least partially non-performing. But theywere always bought at a discount. It is hard togeneralise here, but there may be a moral hazardissue in this case, especially for the foreignlenders who mostly lost very little. Nevertheless,I am not convinced that the adverse effectsof moral hazard should be regarded as out-weighing the very good reasons for govern-ment and central bank rescues. At the sametime, even the solvency problems of the variousprivate sectors in the four countries wouldhave been less if the depreciations had been less(or less sudden) because of readier availabilityof international liquidity. This is particularlytrue in the case of Indonesia. Thus there waseven a liquidity crisis element affecting theprivate sectors’ problems. This large issue of‘liquidity versus solvency crisis’, I cannotpursue here. It is one which is familiar tostudents of central banking, and which underliesmuch of the discussion of the role of the‘domestic lender of last resort’ in Kindlebergerand Aliber (2005:195–210).

Conclusion

Let me reiterate that this lecture has not beenconcerned with assessing the role of the IMF,


12



even though I have touched on this at variouspoints. The role and presumed failures of theIMF are interesting and much debated subjectsthat are probably discussed most thoroughlywith regard to Korea and Indonesia in the IMF’sown report by the Independent EvaluationOffice (2003).

The main point of my review here has beenthat there was a prolonged investment boomfollowed inevitably by some kind of slump.An ending to the episode in the form of a‘hard landing’ was neither inevitable nor pre-dictable, but was set off by events in Thailandand reinforced in Indonesia’s case by politicalfactors. I have discussed the relationshipbetween the hard landing and the exchangerate crises and the serious impact of short-term foreign borrowing that was not onlydenominated in foreign currency (usually theUS dollar) but was also unhedged. There

were several policy responses, notably effortsto rescue the banks and various private cor-porations, and these rescues were generallyexpensive to the public sector. Only in theKorean case was there a systematic attempt tohave foreign creditors reschedule the paymentsthey were owed. There were some specialfeatures of each of our four countries. In par-ticular, in Indonesia there was the interactionof a political with an economic crisis, whileMalaysia did not incur significant short-termdebts—unlike the other three crisis countries—and Thailand adhered too long to a fixedexchange rate. As I have said at the beginningof this lecture, I have not tried to make a grandassessment of the East Asian financial crisisnor provide a prescription for preventing futurecrises; rather, I have presented a limited over-view of the causes of the crisis and policyresponses in four principal nations examined.

References

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Crisis and Recovery inMalaysia: the role of capital controls

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Documents

The Asian Crisis: a perspective after ten years