On the 2nd of July 1997, Asia was hit by one of the most devastating financial
crises it has ever seen. Of all the financial crisis that have taken place, this
was one of the most distressing in that it was totally unexpected. The purpose
of this paper is to show that particular developmental strategies employed by
these economies eventually led to their downfall. It will attempt to find out
where the origins of the crisis lie, and what events started the cycle that
eventuated with this disaster. In order to trace the events that led to the
eventual collapse of the Asian economies, one must venture across the ocean to
the United States. The issue of liberalisation first gained attention in the US
during the Regan Administration. However, it was during the Clinton era that
liberalisation became a top priority. Whereas previous governments had pushed
for the liberalisation of Japan, one of Clinton’s main foreign policy
objectives was the liberalisation of the Asian economies. This process was
pushed forth in Asia with such vehemence because the region held a lot of
investment opportunities for American Banks, Brokerages, and other financial
sector businesses. Unfortunately, Asia’s economies were not structurally ready
to deal with the influx of capital that was headed their way. They had weak
banking and legal systems that were unable, or unwilling, to regulate the flow
of foreign capital in the country. The Americans eventually persuaded Korea to
relax its capital flow regulations by giving it the option of joining the
Organisation for Economic Co-operation and Development. Even then, Korea was
concerned that its financial institutions may not be able to deal with an influx
of foreign capital. One fatal mistake that Korea, as well as other Southeast
Asian countries made, was that they opened their capital markets in the wrong
way. They did not allow long term investments in Korean companies, but rather,
only short-term investments that could be removed easily. One example of the
sort of quick investments that were being made in Asia can be seen in the
Japanese. In Japan the interest rates were very low, so investors would borrow
at 2 percent and then convert their currency into Thai baht. Due to the interest
rate differential, they were able to make a lot of money off simple currency
conversion. Other Asian economies were quick to follow suit, and soon there was
a movement of huge amounts of capital into the region. In just one year, more
then $93 billion was invested in five Asian countries. One must, however,
concede that Southeast Asia became very receptive to the changes being imposed
on them by the United States. Eventually, foreign investment came to be seen as
a miracle cure for underdevelopment. It was seen as a quick fix that could, in a
short period of time, bring countries to the same level of development as the
West. The trouble started in 1995, when the United States inflated the dollar,
and hence also inflated the Thai baht and other Asian currencies that were
pegged to the dollar. This caused their exports to become expensive compared to
Chinese exports. The Thai deficit rose to such an extent that all their foreign
currency reserves started to drain in order to pay it. This is the first time
that investors got to see the weakness in the Thai financial market. It is not
possible to place the entire blame for the crisis on the United States. As was
mentioned before, Asian countries were more than happy to accept the capital
coming there way. It is important to evaluate the different internal weaknesses
in these economies that led to the eventual crisis. Enough stress can not be
placed on how the internal weaknesses of the Asian region led to this crisis.
The remainder of this essay with deal with these weaknesses, and of the events
that eventually led to the collapse of the East Asian miracle. Liberalisation in
Southeast Asia took place primarily in two steps. In Thailand, and in much of
Asia, this liberalisation consisted of the removal of foreign exchange controls,
interest rate restrictions, encouragement of nonbank (private) capital markets,
and the adoption of the capital adequacy standard for bank supervision. This
liberalisation led to intense competition in the Thai market. Banks competed on
the size of their portfolios, and this led to some of the frivolous, short term,
investment that became synonymous with the region. They also competed to
generate off-balance sheet transactions and quasi-banking operations, all of
which added to the vulnerability of the region. In Indonesia, as well, there was
a removal of banking regulations. With the removal of these regulations, the
number of banks in the country more than doubled in a period of six years. Many
of these banks were owned by large industrial groups, which used them to manage
their own financial affairs. Banks also created Offsure accounts in order to
conduct illegal activity. This first liberalisation actually went a long way in
reducing the reliability of banks. Investments were made without paying proper
heed to their long-term returns and the credit worthiness of the parties. This
combined with illegal activities made the banking system extremely susceptible
to any sort of external pressure. One example of this type of short sighted
activity can be seen in the expansion of bank portfolios to include a large
number of property companies. Property companies would borrow from banks and
then float shares for the property in the stock market. They money made in this
way would be enough to pay the banks and make a profit. The second phase of the
liberalisation process consisted of openeing up the capital accounts of the
region. Guarantees were given to non-residents that they would be able to
withdraw their investments and, also, the end of restrictions regarding foreign
asset holding by residents. It is this phase that defined East Asian growth for
almost a decade. For the first time Thailand’s companies had access to
external finance. This relationship between the corporations and the outside
world also made this sector vulnerable to external changes. The level of capital
inflow in Asia reached monumental proportions due to another reason as well.
Before the liberalisation measures were implemented, these countries had
provided incentives in the form of subsidies to foreign investors. Once the
liberalisation was complete, these subsidies remained. This added an additional
incentive for foreign incentive. Besides this, the interest rate differential
between the developing and western countries was so great, local businesses had
an incentive to move towards foreign funding. In short, both the banking and
corporate sector became extremely dependent on foreign short-term debt
liabilities. Some Asian countries could see where this type of short-term
speculation was leading, but they were not willing (or unable) to impose
regulations on banks and investors. Malaysia was one country that was able to
reduce the degree of short-term speculation through a combination of various
measure. At one point net inflows of capital actually went into the negative.
Thai authorities, on the other hand, were unwilling to intervene to take control
of their current accounts deficit. They felt that it was inappropriate for a
government to intervene on behalf of a deficit that was caused purely by the
private sector. Similarly, in Indonesia also the current account deficit started
becoming a representation of private investments. Theories, like the one
expressed by Cordon, imply that market forces will take care of any current
account deficit. However, in an unusual situation like this, where enormous
amounts of capital is available for short-term profit, private agents do not
always behave rationally. These countries themselves provided investors with
conditions that led to irrational behaviour. The adoption of a fixed exchange
rate and an absolute commitment to an unregulated capital account made for good
hunting. In these instances measures to keep the current account under control
are essential. Through this entire process, Thai governments were playing a
delicate game trying to balance the exchange rate and the interest rate. It was
imperative for these economies that the exchange rate should not appreciate.
They engaged in sterilisation operations in order to keep the exchange rate at
certain level. However these activities caused interest rates to increase, which
again caused more foreign capital to come into the countries. The East Asian
economies, by the mid 90’s were like a card house. Their foundation cards were
foreign investment and a fixed exchange rate. Foreign investment had provided
all the funding for banks in their ill-conceived ventures. It was this money
that allowed economies with very basic discrepancies to achieve such high growth
rates. The fixed exchange rate was necessary to keep foreign investment coming.
In 1995 when the value of the Thai baht, and other East Asian currencies that
were pegged to the dollar, increased in response to a corresponding increase in
the dollar, it set off a chain of events that ended with the destruction of the
East Asian economies. The inflation of the baht led to an increase in the
current account deficit. Foreign currency reserves were exhausted in an attempt
to pay for the deficit. This economic instability caused panic selling by
investors. Thailand refused to devalue its currency, and in response interest
rates went up in Thailand and in the Philippians. Under increasing pressure that
the flight of capital created, the Thai government eventually let the baht float
freely. In the open market the baht hit a record low of 28.8 against the dollar.
The Philippians also lets their currency, the peso, float semi-freely with the
result that it also ended at a record low of 32.38 against the dollar. As the
effects of this currency devaluation swept throughout Southeast Asia, there was
a multilateral currency meltdown. Dozens of financial firms in the region were
closed and their operations came under scrutiny. Banks stopped extending
short-term loans due to a dry up of capital and business, unable to pay back,
went bankrupt. Essentially what happened is that faced with the prospect of
economic instability in the region investors started selling their stakes in
these economies. As the money dried up, the entire system that had developed
around this money also crumbled. When an economy is built on such delicate
cards, even a slight change in any one factor (in this case the exchange rate)
and lead to a catastrophe. What is interesting is that even though all areas of
Asia (in fact the entire world) were hit by the crisis, certain countries
weathered the crisis better. Singapore and the Philippines, who had exercised
come capital control and had placed prudential regulations on their banks, were
able to recover from the crisis much faster. In fact, that they were even hit by
the crisis is due more to the non-availability of financial information in the
region than anything else. The crisis caused general selling by investors in the
entire region who did not have time to differentiate between the various amount
of economic distress in the region. Essentially, it was due to some level of
Contagion. As you can see, a variety of factors went into the destruction of the
Southeast Asian economies. The Americans failed to realise that under the
conditions that existed in the region, uncontrolled capital liberalisation would
not work. The influx of capital overwhelmed societies, which were not equipped
with the knowledge to deal with it. The entire system was dependent on a
delicate balance between exchange rates and other monetary factors. In the end
the over liberalisation of these economies, without sufficient controls led to
one of the most dramatic crisis of all time. In response one can not help but
wonder if capital mobility is more a need of the west than of the east.
Underdeveloped countries need time to develop the institutional framework to
handle this new form of Globalisation. Until then, they can not be fully
integrated into the world capital market.