What caused the Asian Financial crisis?

Thu Thi Hoang: Macroeconomic weaknesses

John Parker: Financial intermediaries & “The Bubble”

Mark Steingraeber

Bernard Villanueava

Brian Ikihara

Asian financial crisis overview

The Asian financial crisis is considered to have started on July 2, 1997 with the devaluation of the Thai baht and ask IMF for assistance.

Malaysia abandons the peg and blames the speculators on July 14 Philippines seek assistance form IMF

Indonesia floats on August 14, go to the IMF on October 8

Repeated speculative attacks on Hong Kong dollar unsuccessful, but stock market plunges between October 20-23

Global stock market decline on October 27

S. Korea devalue Nov. 28 and ask for IMF assistance

Spread over other Asia countries

Macroeconomic weaknesses

• Large current account deficit

• Large capital inflows

• Large exchange rate depreciations

• Bank lending

Current account deficits

Large capital inflowsLarge capital inflows

• Large capital inflows, especially those deriving from foreign borrowing.

• These inflows equivalent 1990-1996– Korea: 2.5% of GDP– Thailand: 10%– Indonesia: 3.5%

Large capital inflows

• They were encouraged by high economic growth, low inflation and relatively healthy fiscal performance (table1 and figure 2)

Large exchange rate depreciation (to the US Dollar)

Period averagePeriod averageSource: International Financial Statistics ( IMF)Source: International Financial Statistics ( IMF)

1990 1991 1992 1993 1994 1995 1996 1997

Korea 707 733 780 802 803 771 804 951

Indonesia 1824 1950 2029 2087 2160 2248 2342 2909

Malaysia 2.70 2.75 2.55 2.57 2.62 2.50 2.52 2.81

Philippines 23.3 27.4 25.51 27.12 26.42 25.7 26.22 29.47

Thailand 25.5 25.5 25.40 25.32 25.15 24.9 25.34 31.36

Large exchange rate depreciations (cont.)

Inflexible exchange rate regimes complicated macroeconomic management and increased vulnerability.

Nominal exchange rate had depreciated in a predictable manner in Indonesia, and was closely linked to the U.S in Malaysia, the Philippines and Thailand.

The crisis countries were vulnerable to capital outflows and exchange rate devaluations because of the significant amount of short term foreign currency debt, which was mostly unhedged.

Bank lending

• Private credit sector in nominal terms expanded rapidly during the 1990s, at an average rate of 15 to 20% compared to inflation rates of 3-10%.

Bank lending (cont.)

• Bank lending relied collateral rather than credit assessment and cash flow analysis, making banks vulnerable to excessive risk and declines in asset values.

What caused the Asian Financial Crisis Part II Two conventional models.

“The First Generation” crisis model (Krugman 1979; Flood and Garber 1984) describes a government with persistent money financed budget deficits that uses its limited reserves to peg its exchange rate. This will of course be ultimately unsustainable. At some point a speculative attack will occur when investors believe collapse is imminent.

“The Second Generation” crisis model (Obstfeld 1994, 1995) describes a government making a tradeoff between short-run macroeconomic flexibility and longer- term credibility. In this model higher interest rates are required to defend parity if the market defense of the peg will ultimately fail. A speculative attack can develop either as a result of an expected future failure or as a “self-fulfilling prophecy.”

As useful as these two models have been describing most historical currency crisis; they fail to explain the AFC.

First, none of the governments were engaged in irresponsible monetary expansion, in fact their inflation rates were quite low. On the eve of the crisis all of the governments were more or less in fiscal balance.

Second, the Asian countries did not have a troubling level of unemployment. Therefore there did not seem to be any pressure to abandon the fixed exchange rate in favor of monetary expansion.

Third, there was already a boom bust cycle in the asset markets that preceded the currency crisis.

Fourth, in all countries involved in the AFC, financial intermediaries seem to have been central players in the crisis. In Thailand so called “finance companies” – nonbank intermediaries that borrowed short-term money then lent to speculative investors played a crucial role.

What are Financial Intermediaries and what role did they play in the crisis?

“financial intermediaries” were institutions perceived as having implicit government guarantees but were in most part unregulated and subject to sever “moral hazard” problems

Unrestrained risky lending by these institutions caused inflation of asset prices (but not consumer goods). This over pricing of assets was sustained by a sort of circular process of reinforcement. The proliferation of risky lending drove up asset prices making the collateral position of the lending institutions seem stronger than it actually was. Also, the appearance of soundness of the position of financial institutions further increased risky loans putting even more upward pressure on asset prices.

Then the bubble burst!

The reverse of the upward spiral occurred with a vengeance. Falling asset prices quickly made financial institutions insolvent forcing them to cease lending which led to a further acceleration of asset depreciation. This reinforcing circular decline can explain the contagious nature of the crisis to countries without visible economic links. Other countries where the asset bubble had not yet burst suffered a decline of investor confidence because of the suddenness, severity and unpredictableness of the Thai crises which in turn led to self fulfillment of the crisis in that country. The loss of investor confidence caused a decline in asset prices which then followed the reinforcing downward spiral of asset prices and collapse of financial intermediaries as in Thailand.

Although the moral hazard/asset bubble view is not the full story of the cause of the crises, it is surely a leading contender as a primary cause.

How do we resolve baffling nature of the AFC:

The problem was off the government balance sheet. The fact that government guarantees of the financial institutions was at best implicit, made these liabilities invisible until after the fact. Even the implicit guarantees of the US S&Ls in the 1980s was not a visible government liability until they actually failed.

The boom and bust cycles of the asset market preceded the currency crisis because the financial crisis was the real cause of the whole process with currency fluctuations a result rather than a cause of the AFC.

The AFC was able to spread without specific exogenous shock to other Asian economies because of vulnerability to self-fulfilling pessimism which generated a downward spiral of asset deflation and disappearance of a financial intermediation structure.