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
1
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 turbulences of Mexico and European Monetary system of early 90s Asian crisis surprised everyone with its scale and depth. A major 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 instability associated associated with it. It has also raised doubt over 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.
2
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 IMF’s role
14
5
Lessons from the crisis
23
6
Source of data and References
26
3
1. Introduction 1.0 introduction 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 IMF’s 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
4
1.1 SE Asian nations before the crisis Until 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 developing nations. Figure 2 presents presents the GDP growth rates of period for these nations -
annual GDP growth rate %
20.00
15.00
10.00
5.00
0.00 1970
1975
1980
1985
1990
1995
-5.00
-10.00
-15.00
Thailand Korea, Rep. Indonesia Singapore
Hong Kong SAR, China Malaysia Philippines
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. 5
2.0 Factors responsible for the crisis 2.1 External 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. Thailand’s CAD was unsustainably unsustainably high high at 8 % of GDP in year 1995 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 c ountries 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 Malaysi a
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
6
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 2 Nominal Exchnage rates , Per US$ , period average
1997
1996
1995
Source – World Bank databank
Countries
1999
1998
1994
1993
1992
1991
1990
Thailand Indonesia Korea, Rep. Malaysia Malays ia Philippines Philippin es
37.81 7855.15 1188.82 3.80 39.09
41.36 31.36 25.34 24.92 25.15 25.32 25.40 25.52 25.59 10013.62 2909.38 2342.30 2248.61 2160.75 2087.10 2029.92 1950.32 1842.81 1401.44 951.29 804.45 771.27 803.45 802.67 780.65 733.35 707.76 3.92 2.81 2.52 2.50 2.62 2.57 2.55 2.75 2.70 40.89 29.47 26.22 25.71 26.42 27.12 25.51 27.48 24.31
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 7 .97
9.43 9.4 3
8.52
9.69
7.53 7. 53
9.42
7.81
Philippines Philippine s
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
7
Table 4 Real exchange rates
2.2 Dependence on short term capital inflow Driving 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 year’s 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
Indonesia Net Private capital flow Net direct investment Net portfolio investment Other net investment Thailand Net Private capital flow Net direct investment Net portfolio investment Other net investment Philippines Net Private capital flow Net direct investment Net portfolio investment Other net investment Korea Net Private capital flow Net direct investment Net portfolio investment Other net investment Malaysia Net Private capital flow Net direct investment Net portfolio investment Other net investment
1983–88
1989–95
1991
1992
1993
1994
1995
1996
1997
1.5
4.2
4.6
2.5
3.1
3.9
6.2
6.3
1.6
0.4
1.3
1.2
1.2
1.2
1.4
2.3
2.8
2
0.1
0.4
—
—
1.1
0.6
0.7
0.8
–0.4
1
2.6
3.5
1.4
0.7
1.9
3.1
2.7
0.1
3.1
10.2
10.7
8.7
8.4
8.6
12.7
9.3
–10.9
0.8
1.5
1.5
1.4
1.1
0.7
0.7
0.9
1.3
0.7
1.3
—
0.5
3.2
0.9
1.9
0.6
0.4
1.5
7.4
9.2
6.8
4.1
7
10
7.7
–12.6
–2.0
2.7
1.6
2
2.6
5
4.6
9.8
0.5
0.7
1.6
1.2
1.3
1.6
2
1.8
1.6
1.4
—
0.2
0.3
0.1
–0.1
0.4
0.3
–0.2
–5.3
–2.7
0.9
0.2
0.6
1.1
2.5
2.4
8.5
4.5
–1.1
2.1
2.2
2.4
1.6
3.1
3.9
4.9
2.8
0.2
–0.1
–0.1
–0.2
–0.2
–0.3
–0.4
–0.4
–0.2
0.3
1.4
1.1
1.9
3.2
1.8
1.9
2.3
–0.3
–1.6
0.8
1.3
0.7
–1.5
1.7 1.7
2.5
3
3.4
3.1
8.8
11.2
15.1
17.4
1.5
8.8
9.6
4.7
2.3
6.5
8.3
8.9
7.8
5.7
4.8
5.1
5.3
-
-
-
-
-
-
-
-
-
0.8
2.3
2.9
6.2
9.7
–4.2
4.1
4.5
–0.6
9
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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2.3 Weak 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 huge amount of non-performing loans. It is also important to note that with rapid growth of lending, banking institutions could not add the necessary managerial managerial capital (well-trained (well-trained loan officers, riskassessment 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, 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 crisis 3.1 The 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 Late 1996
Events Thai Exports began to stumble while boom in Thai real estate continued
Remarks Speculators began attacking Thai currency
1996 and early 1997
The Thai Baht faces speculative attacks
Fall of stock market throughout the year
Early 1997
Seven 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. confidence.
July 2, 1997
Thai Baht is free floated, currency defense is abandoned
To avoid default in international international debt
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-97
Hong Kong Dollar under speculative attack
Oct-97
Further devaluations in Thailand, Indonesia, Malaysia and Philippines
JUL - Aug 1997
12
Oct-97
Taiwan forced to devalue its currency
Oct-97
Hong Kong Stock Exchange wipes $29.3 billion off the value of stock shares.
Nov-97
Indonesia finalizes deal with IMF for funding of 42.3 Billion $
Nov-97
Korean Won collapsed under speculative attacks
Bank of Korea allows the won to fall below 1000 against the dollar (record low)
IMF rescue package of 58.2 Billion $ for South Korea
Korean currency switched to floating on Dec 16th
December 4, 1997
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
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-98
change 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
Sharp fall (~25%) in western stock markets
Russia in trouble, Monetary authorities impose 90 day moratorium over foreign currency debt.
Russia abandons defense of currency Korea lowers short term interest rates
Russian Government defaults defaults on its obligations in September.
Jul - Aug 1998 Sep-98 Sep-98 2001
Recovery starts to take concrete foothold
Economic activity slows down. 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 IMF’s role 4.1 Impact 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 inflation and of monetary tightening as well as a portfolio shift away from emerging market 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 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 nation’s 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. 14
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 region’s 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, having seen 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 1½% 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
Trade as proportion of
crisis economies
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. 4.2 South East Asian Crisis and India Since 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
16
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. Chidambaram’s 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 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. 17
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 7 th 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. We continued 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. 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 convertibilityconvertibility- 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 India’s 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
18
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 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 largely driven 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 o f short term debts which worsened their situation. 4.3 Role of IMF International Monetary Fund injected liquidity into the markets; and tried to take situation into hands to control it. The IMF’s 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 assistanceassistance- 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 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 Programme Programme In 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 IMF’s 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 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, countries, the IMF programs arranged for: · The closure of unviable financial institutions, with the associated write down of shareholders’ capital; · The re-capitalisation re-capitalisation of undercapitalised undercapitalised institutions; · Close supervision of weak institutions; institutions; · Increased potential for foreign participation in domestic financial systems. 4.4 Criticism 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 20
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 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 was criticized. The role of external factors factors such as poor judgements of huge institutional institutional investors, 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. 4.5 Our view point: 1. Essential follies of Business Cycles Whenever 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. 21
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 standards Financial 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 or economies 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 be created. The present bodies like IMF, IMF, World Bank, WTO etc. need 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 governance While the world is increasingly 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. 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 macro-economic indicators for individual as well as world economy.
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5.0 Lessons from the crisis 5.1 Risks 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. 5.2 Strengthening of financial system in emerging economies – A very immediate lesson that can be drawn from the crisis is to strengthen the financial system’s 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 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
23
regard to repay-ability. repay-ability. Such practices are criticized criticized as “crony capitalism”. This eventually led to non-performing non-performing loans and acted as one of the major causes. At the same time it’s prudent to develop a balanced financial market. It’s important to highlight here that Asian economy have a very high saving’s 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 region’s 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 term interests 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 Malaysi a
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 Philippine s
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
5.3 International lender-of-last-resort lender-of-last-resort Most of the emerging economies 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 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 for financial 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%20Finance 2. 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. consequences. World Development , 26(8), 1535-1553.
2. Chowdhry, B., & Goyal, A. (2000). Understanding 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. 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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