FRBSF Economic Letter
98-24; August 7, 1998
What Caused East Asia's Financial Crisis?
The collapse of the Thai baht in July 1997 was followed by an unprecedented
financial crisis in East Asia, from which these economies are still struggling
to recover. A great deal of effort has been devoted to trying to understand
its causes. One view is that there was nothing inherently wrong with East
Asian economies, which have historically performed very well. These economies
experienced a surge in capital inflows to finance productive investments
that made them vulnerable to a financial panic. That panic--and inadequate
policy responses--triggered a region-wide financial crisis and the economic
disruption that followed (Sachs and Radelet 1998).
An alternative view is that weaknesses in Asian financial systems were
at the root of the crisis. These weaknesses were caused largely by the
lack of incentives for effective risk management created by implicit or
explicit government guarantees against failure (Moreno, Pasadilla, and
Remolona 1998 and others cited below). The weaknesses of the financial
sector were masked by rapid growth and accentuated by large capital inflows,
which were partly encouraged by pegged exchange rates.
While the two views are not mutually exclusive, their policy implications
vary greatly. If a panic unrelated to fundamentals fully explains Asia's
financial crisis, reforms in the economic structure or in financial sector
policy are not essential in planning Asia's recovery. If, however, weaknesses
in the financial sector were important contributors to the crisis, reforms
are indeed essential. To shed further light on this question, this Economic
Letter briefly reviews Asia's recent financial crisis and the two
alternative views of its cause.
Boom and bust in Asia
Operating in an environment of fiscal and monetary restraint, most of
East Asia enjoyed high savings and investment rates, robust growth, and
moderate inflation for several decades. Starting in the second half of
the 1980s, rapid growth was accompanied by sharp increases in asset values,
notably stock and land prices, and in some cases by rapid increases in
short-term borrowing from abroad.
After the mid-1990s a series of external shocks (the devaluation of
the Chinese remnimbi and the Japanese yen and the sharp decline in semiconductor
prices) adversely affected export revenues and contributed to slowing
economic activity and declining asset prices in a number of Asian economies.
In Thailand, these events were accompanied by pressures in the foreign
exchange market and the collapse of the Thai baht in July 1997.
The events in Thailand prompted investors to reassess and test the robustness
of currency pegs and financial systems in the region. The result was a
wave of currency depreciations and stock market declines, first affecting
Southeast Asia, then spreading to the rest of the region. In the year
after collapse of the baht peg, the value of the most affected East Asian
currencies fell 35-83% against the U.S. dollar (measured in dollars per
unit of the Asian currency), and the most serious stock declines were
as great as 40-60%.
Disruptions in bank and borrower balance sheets have led to widespread
bankruptcies and an interruption in credit flows in the most severely
affected economies. As a result, short-term economic activity has slowed
or contracted severely in the most affected economies.
Interpreting the crisis
The economic shocks affecting East Asia were not followed by a normal
cyclical downturn, but what some describe as "runs" on financial
systems and currencies. Some argue that these runs reflected a classic
financial panic that did not reflect poor economic policies or institutional
arrangements. As is well known, even well-managed banks or financial intermediaries
are vulnerable to panics, because they traditionally engage in maturity
transformation. That is, banks accept deposits with short maturities
(say, three months) to finance loans with longer maturities (say, a year
or longer). Maturity transformation is beneficial because it can make
more funds available to productive long-term investors than they would
otherwise receive. Under normal conditions, banks have no problem managing
their portfolios to meet expected withdrawals. However, if all depositors
decided to withdraw their funds from a given bank at the same time, as
in the case of a panic, the bank would not have enough liquid assets to
meet its obligations, threatening the viability of an otherwise solvent
As pointed out by Radelet and Sachs (1998), East Asian financial institutions
had incurred a significant amount of external liquid liabilities that
were not entirely backed by liquid assets, making them vulnerable to panics.
As a result of this maturity transformation, some otherwise solvent financial
institutions may indeed have been rendered insolvent because they were
unable to deal with the sudden interruption in the international flow
However, it is apparent that this is not the entire story, as the impact
of the crisis varied significantly across economies. In particular, as
investors tested currency pegs and financial systems in the region, those
economies with the most vulnerable financial sectors (Indonesia, South
Korea, and Thailand) have experienced the most severe crises. In contrast,
economies with more robust and well-capitalized financial institutions
(such as Singapore) have not experienced similar disruptions, in spite
of slowing economic activity and declining asset values. Indeed the collapse
of the Thai baht in July 1997 and of the Korean won in the last quarter
of 1997 were preceded by signs of significant weaknesses in the
domestic financial sector, notably an inability by domestic borrowers
to service their debts. In Indonesia, it became apparent after the crisis
that domestic lenders could not monitor adequately the financial condition
of their borrowers, a situation that worsened the severity of the crisis.
This suggests that understanding what factors contributed to weaknesses
in the financial sectors of the most affected economies may help make
them less vulnerable to financial crises in the future.
Lack of incentives for risk management
Two characteristics common in countries that have experienced financial
crises were present in a number of East Asian economies. First, financial
intermediaries were not always free to use business criteria in allocating
credit. In some cases, well-connected borrowers could not be refused
credit; in others, poorly managed firms could obtain loans to meet some
government policy objective. Hindsight reveals that the cumulative effect
of this type of credit allocation can produce massive losses.
Second, financial intermediaries or their owners were not expected
to bear the full costs of failure, reducing the incentive to manage
risk effectively. In particular, financial intermediaries were protected
by implicit or explicit government guarantees against losses, because
governments could not bear the costs of large shocks to the payments system
(McKinnon and Pill 1997) or because the intermediaries were owned by "Ministers'
nephews" (Krugman 1998). Krugman points out that such guarantees
can trigger asset price inflation, reduce economic welfare, and ultimately
make the financial system vulnerable to collapse.
The importance of implicit government guarantees in the most affected
economies is highlighted by the generous support given to financial institutions
experiencing difficulties. For example, in South Korea, the very high
overall debt ratios of corporate conglomerates (400% or higher) suggest
that these borrowers were ultimately counting on government support in
case of adverse outcomes. This was confirmed by events in 1997, when the
government encouraged banks to extend emergency loans to some troubled
conglomerates which were having difficulties servicing their debts and
supplied special loans to weak banks. These responses further weakened
the financial position of lenders and contributed to the uncertainty that
triggered the financial crisis towards the end of 1997.
Why a crisis now?
Since weaknesses in East Asian financial systems had existed for decades
and were not unique to the region, why did Asia not experience crises
of this magnitude before? Two explanations are likely. First, rapid growth
disguised the extent of risky lending. For many years, such growth allowed
financial policies that shielded firms that incurred losses from the adverse
effects of their decisions. However, such policies would make economies
highly vulnerable during periods of uncertainty. Second, innovations in
information and transactions technologies have linked these countries
more closely to world financial markets in the 1990s, thus increasing
their vulnerability to changes in market sentiment.
Closer integration with world financial markets adds dimensions of vulnerability
that are not present in a closed economy. In a closed economy, bad loans
caused by risky lending may not lead to a run because depositors know
that the government can supply enough liquidity to financial institutions
to prevent any losses to depositors. In an open economy, that same injection
of liquidity can destabilize the exchange rate. As a result, during periods
of uncertainty, runs or speculative attacks on a currency can be avoided
only if the holders of domestic assets are assured that the government
can meet the demand for foreign currency. Those East Asian economies where
foreign exchange reserves were large relative to their short-term borrowing
(Philippines, Malaysia, and Taiwan) were in a better position to provide
such assurances than those economies where such reserves were relatively
low (South Korea, Indonesia, and Thailand). (Singapore and Hong Kong are
excluded from this comparison because their role as offshore financial
centers clouds interpretation of the data.)
Financial sector vulnerability was accentuated by a tendency not to
hedge foreign currency borrowing in countries with pegged exchange rates.
Market participants may have interpreted currency pegs as implicit government
guarantees against the risk of currency volatility (Dooley 1997), backed
by foreign reserves that would be made available through central bank
currency intervention. While the absence of hedging significantly lowered
the cost of funds (in the short run) for those firms with access to foreign
credit, the consequent mispricing of foreign credit contributed to excessive
capital inflows and the vulnerability of borrowers with heavy exposure
to foreign currency loans.
The lack of hedging also added to the instability in Asian financial
markets once the crisis hit. The high cost of abandoning currency pegs
induced policymakers to adopt harsh contractionary measures (involving
skyrocketing interest rates) to defend the exchange rate, even when the
pegs were unsustainable in the face of adverse market sentiment. The efforts
of market participants to cover previously unhedged foreign currency exposure
after the onset of the crisis further weakened Asian currencies. After
the pegs collapsed, borrowers who had not hedged their foreign currency
borrowing had difficulty servicing their debts and, in some cases, went
bankrupt, thus worsening the crisis.
A review of East Asia's experience suggests that while a classic panic
may have played a role, financial sector weaknesses were a major contributor
to the recent financial crisis. Such weaknesses appear to reflect the
inability of lenders to use business criteria in allocating credit and
implicit or explicit government guarantees against risk. This implies
that it would be prudent to accompany efforts to spur recovery in East
Asia by reforms designed to strengthen the financial system.
Dooley, Michael. 1997. "Are Recent Capital Inflows to Developing
Countries a Vote for or against Economic Policy Reforms?" In Exchange
Rates, Capital Flows, and Capital Mobility in A Changing World Economy,
William Gruben, et al., eds. Boston: Kluwer Academic Publishers.
Krugman, Paul. 1998. "What
Happened to Asia?" Manuscript. MIT. January.
McKinnon, Ronald, and Huw Pill. 1997. "Overborrowing: A Decomposition
of Credit and Currency Risk." Unpublished manuscript. Harvard Business
Moreno, Ramon, Gloria Pasadilla, and Eli Remolona. 1998. "Asia's
Financial Crisis: Lessons and Policy Responses." In Asia: Responding
to Crisis. Tokyo, Asian Development Bank Institute. Also Working
Paper PB98-02, Center for Pacific Basin Monetary and Economic Studies,
Federal Reserve Bank of San Francisco.
Radelet, Steven, and Jeffrey Sachs. 1998. "The Onset of the East
Asian Financial Crisis." Manuscript. Harvard Institute for International
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