Asian Financial CrisisCauses,Lessons learned and

Reforms

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Contents

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Introduction
Timeline
Causes
Lessons Learned
Reforms considered post crisis
Rethinking capital controls
Appropriate exchange rate regime
Strengthening financial sector
AMF proposal
Exchange rate arrangements
Conclusion

Introduction
On July 2, 1997 the thai baht which had been largely fixed to the US dollar was suddenly
devalued. What at first appeared to be a local financial crisis in Thailand quickly escalated into a
global financial crisis. First it spreaded over to other asian countries. Indonesia , korea, Malaysia
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and the Philippines and then it spread to far off places like Russia and Latin America especially
Brazil. At the height of the crisis Korean currency fell by about 50% in its dollar value from its
pre crisis level whereas Indonesian rupiah fell as much as 80 %.
The 1997 Asian financial crisis, is the third major currency crisis of the 1990s precede by the
crisis of the European monetary system of 1992 and the Mexican peso in 1994-95. The Asian
crisis however turned out to be more serious than the other two, considering the security of the
resultant economic and social costs. Following the massive depreciation of local currencies,
financial institutions and corporations with foreign currency debts in the affected countries were
driven to extreme financial distress and many more forced to default. What was worse the
currency crisis led to an unprecedented, deep, widespread and long lasting recession in east asia
prior to the crisis, east asia region, for the last four decades has enjoyed the most rapidly growing
economy in the world. As a result of the crisis money lenders and investors from the developed
countries also suffered large capital losses from their investments in emerging market security.
The sequence of events triggered a self-reinforcing spiral of panic, which many analysts argue
was premised on a confluence of the inherent volatility of financial globalization and the weak
domestic financial systems in East Asia. Financial liberalization in the region led to surges in
capital flows to domestic banks and firms, which expanded bank lending, ultimately resulting in
a rapid accumulation of foreign debt that exceeded the value of foreign exchange reserves. As
international speculation on dwindling foreign reserves mounted, the regional currencies came
under attack.
During the summer of 1997, Thailand sharply reduced its liquid foreign foreign exchange
reserves in a desperate attempt to defend its currency. When the Thai baht was cut loose from its
dollar peg, regional currencies plunged in value, causing foreign debts to skyrocket and igniting
a full-blown crisis.1 By mid-January 1998, the currencies of Indonesia, Thailand, South Korea,
the Philippines, and Malaysia had lost half of their pre-crisis values in terms of the U.S. dollar.
Thailands baht lost 52 percent of its value against the dollar, while the Indonesian rupiah lost 84
percent. During the last stages of the Asian crisis, the regional financial tsunami generated a
global one as Russia experienced a financial crisis in 1998, Brazil in 1999, and Argentina and
Turkey in 2001.

The various participants in the Asian crisis ranged from Wall Street to Jakarta. Asian and
Western governments, the private sector, and the International Monetary Fund (IMF, or the
Fund), established to provide temporary financial assistance to help countries ease balance of
payments adjustments, all played crucial roles in the sequence of the crisis. Perhaps the most
controversial role was that of the IMF. Its critics argue that the stringent monetary policies and
financial sector reforms attached to the Funds loan programs exacerbated the crisis, while its
supporters maintain that those very policies helped to dampen the effects of the crisis.
Governments, banks, and firms in the crisis-affected countries were charged with fundamental
weaknesses, in that a lack of transparency and regulatory oversight in domestic financial
systems and institutions was at the roots of the crisis. The international market was seen to have
acted in panic, as a herding effect prompted a massive capital outflow from the East Asian
countries.
The resulting economic recession shocked the world with its staggering economic and social
costs. Over a million people in Thailand and approximately 21 million in Indonesia found
themselves impoverished in just a few weeks, as personal savings and assets were devalued to a
fraction of their pre-crisis worth. As firms went bankrupt and layoffs ensued, millions lost their
jobs. Soaring inflation raised the cost of basic necessities. Strapped fiscal budgets imposed a
financial squeeze on social programs, and the absence of adequate social safety nets led to grim
economic displacement. Poverty and income inequality across the region intensified, as a
substantial portion of the gains in living standards that had been accumulated through several
decades of sustained growth evaporated in one year.
The severity of the Asian financial crisis came as a genuine surprise to many in the international
community because the affected countries were the very economies that had achieved the East
Asian miracle. The East Asian miracle that saw the transformation of 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. Overall poverty rates for East Asia
fell from roughly 60 percent in 1975 to 20 percent in 1997. So, what happened? How did the
very economies that were being praised for their dramatic success turn into the same ones being
reprimanded for their collapse?
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Timeline of Crisis

May 1997:Thailand, with the intervention of Singapore, spends billions of dollars of its

foreign reserves to defend the Thai baht against speculative attacks.

July 1997:
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 Thailand devalues the baht. News of the devaluation drops the value of baht by as
much as 20%- a record low. The thai government requests technical assistance
from the international monetary fund (IMF).
Malaysia's central bank intervenes to defend its currency, the ringgit.
The Philippine peso is devalued. Indonesia widens its trading band for the rupiah
in a move to discourage speculators.
The IMF announces it will make more than a billion dollar available to the
phillipines to help relieve the pressure on peso. This action of IMF was the first
use of its emergency funding of mechanisms
The Singapore dollar starts a gradual decline. The then Malaysian PM accuses
rogue speculators for the south east asian crisis and thereby singles out billioner

financier George Soros.

August 1997:
Thailand agrees to adopt tough economic measures proposed by the IMF in return
for a $17 billion loan from the international lender and Asian nations. The Thai
government closes 42 ailing finance companies and imposes tax hikes as part of
the IMF's insistence on austerity.
Indonesia abandons the rupiah's trading band and allows the currency to float

freely, triggering a plunge in the currency.

October 1997:
Indonesia asks the IMF and World Bank for help after the rupiah falls more than
30% in two months, despite interventions by the country's central bank to prop up
the currency.

.
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. The plunge on the Hong
Kong Stock Exchange wipes $29.3 billion off the value of stock shares.
The South Korean won begins to weaken.
Rattled by Asia's currency crisis, the Dow Jones Industrial Average plummets 554
points for its biggest point loss ever. Trading on US stock markets was suspended.
The IMF agrees to a loan package for Indonesia that eventually swells to $40
billion. In return, the government closes 16 financially insolvent banks and
promises other wide-ranging reforms.
The IMF announces that it will delay a $700 million quarterly disbursement to
Russia due to the country's lax tax collection.
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November 1997:
Sanyo Securities Co. Ltd, one of Japan's top 10 brokerage firms, goes bankrupt
with liabilities of more than $3 billion. It is the first Japanese securities house to
go bust since World War II.
Hokkaido Takushoku Bank Ltd., one of Japan's top 10 banks, collapses under a
pile of bad loans.
The Bank of Korea abandons its effort to prop up the value of the won, allowing it
to fall below 1000 against the dollar, a record low.
Thereby, South Korea requests IMF aid.
South Korean nationalists criticize the IMF loan request as humiliating. President
Kim Young Sam apologies on television to the country for South Korea's
economic malaise.
At the Asia-Pacific Economic Cooperation (APEC) summit in Vancouver,
President Clinton describes the Southeast Asian economies as temporarily
experiencing a "few glitches in the road."

December 1997:
The IMF approves a $57 billion bailout package to South Korea, the largest in
history. President Bill Clinton earlier urges "tough medicine" for South Korea.
The Thai government announces that it will close 56 insolvent finance companies
as part of the IMF's economic restructuring plan. 30,000 white-collar workers lose
their jobs. Michel Camdessus, the IMF's managing director, praises Thailand for
"solid progress."
The IMF restarts its loan disbursement to Russia. The pact releases $700 million
delayed in October. In the accord, the IMF urges Russia to boost revenues and cut
spending.
Kim Dae Jung becomes South Korea's first president elected from the country's
opposition party. Within days, the South Korean won hits new lows.

 In an unprecedented move, the World Bank releases an emergency loan of $3

billion, part of a $10 billion support package, to South Korea to help salvage its
economy.
Seoul wins an early payment of $10 billion in loans from the IMF and Group of
Seven (G-7) to forestall a default on its short-term loan debts. In return for the aid,
South Korea agrees to expedite financial reforms and open its domestic financial
markets.

January 1998:
In speech given in Helsinki, Finland, the then chief economist of the World
Bank, Joseph Stiglitz, breaks with orthodoxy and questions the assumptions and
effects of the "Washington Consensus.
International creditors agree to a 90-day rollover of South Korea's short-term
debt.
The Indonesian rupiah nose-dives to an all-time low after Indonesian President
Suharto unveils his state budget plan. Critics say that the unrealistic budget does
not comply with the IMF's reform program.
Indonesians clear store shelves of food and staple goods fearing that further
currency declines will lead to food shortages.
Pressured by the IMF to take strong measures against Indonesia's ongoing
economic decline, Suharto postpones 15 major government-subsidized projects--a
number of them linked to members of the Suharto family--to help cut
expenditures and foreign debt.
Asia's largest private investment bank, the Hong Kong-based Peregrine
Investments, files for liquidation. The company is left badly exposed from its loan
investments in Indonesia.
Students in Jakarta rally protested against the IMF-imposed policies.
South Korean labor unions agree to discuss layoffs with businesses and
government leaders. Layoffs are a key condition insisted upon by the IMF in
exchange for the fund's record $57 billion aid package. IMF chief Michel
Camdessus defends the IMF's demand for mass layoffs saying that they are the
only way Seoul can restore its financial credibility and draw in foreign
investment.

 Suharto signs a new loan deal with the IMF agreeing to eliminate the country's
monopolies and state subsidies.
Prices for basic food staples increase by as much as 80%. The IMF signing
follows a week of the rupiah's free-fall--10,000 to the dollar--which prompts
waves of panic buying in Indonesia.
Officials from South Korea meet with international bankers in New York in an
effort to restructure the country's short-term debt.
Indonesia's currency plunges to a new all-time low--12,000 rupiah against the
dollar--amid anxiety over Suharto's apparent choice for vice president-Technology Minister Bacharuddin Jusuf Habibie.
International banks and South Korea agree on a plan to exchange $24 billion of

short-term debt for longer-term loans.

February 1998:
South Korean unions, government and businesses reach a landmark agreement to
legalize layoffs. The legislation is ratified by Seoul's National Assembly.
Camdessus announces that he will extend the IMF's loan program to Russia by
one year. He also says that the IMF will relax the stringent tax-revenue targets that

have been used as a criteria for awarding loans to Russia.

March 1998:
The IMF announces that it is delaying a $3 billion installment of its $40 billion
loan package to Indonesia, citing Suharto's unwillingness to implement his side of
the deal. This prompts a charge from Suharto that the IMF reforms are
"unconstitutional."
Suharto is sworn in for a seventh five-year term as president of Indonesia.
Russian President Boris Yeltsin abruptly dismisses his entire cabinet, including
Prime Minister Viktor Chernomyrdin. Yeltsin appoints Energy Minister Sergei
Kirienko as acting premier.
The US announces that it will send $70 million in food and medical emergency
aid to Indonesia, despite the fact that the IMF had suspended its loan package.

The US emergency aid is intended to quell the increasing food riots.

April 1998:
Indonesia and the IMF reach a third pact in six months for a bailout. Both sides
make concessions: the IMF withdraws its mandate that the government dismantle
its subsidies of food and fuel, Suharto agrees to close more insolvent banks. IMF
Deputy Director Stanley Fischer declares "the worst of the crisis is over."
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May 1998:
The IMF resumes a stalled lending program to Indonesia, approving a payment of
$1 billion.
Students in Indonesia hold demonstrations across the country, protesting steep
fuel and energy price hikes. Student protests denounce the Suharto administration
for its failed economic policies and demand extensive political reforms.
In Indonesia, troops fire into a peaceful protest at a Jakarta university, killing six
students and sparking a week of riots.
Suharto resigns after 32 years in power. Vice President Habibie succeeds as
president.
The IMF indefinitely postpones aid disbursement to Indonesia of $1 billion
scheduled for June. US Treasury Secretary Robert Rubin says the aid should be
delayed until the political situation stabilizes.
Russias financial system is stretched to the breaking point as panic-striken stock
and bond markets continue to plunge, forcing the central bank to triple interest
rates to 150% to avert a collapse of the ruble.
A two-day, nation-wide strike is held in South Korea by union workers to protest
the growing wave of unemployment in the country. Since February, South Korean

companies have been laying off 10,000 workers per day.

June 1998:
Russia's stock market crashes and Moscow's cash reserves dwindle to $14 billion
amid unsuccessful attempts to prop up the ruble and pay off burgeoning debts.
President Clinton pledges support for Yeltsin.
Japan announces that its economy is in a recession for the first time in 23 years.
The yen's fall to levels near 144 to the dollar rattles Wall Street, prompting the US
Treasury and Federal Reserve to intervene to prop up the yen. Japan and the US
spend some $6 billion to buy yen in order to strengthen it. Clinton calls on Tokyo
to quickly resolve its banking problems and stimulate the economy.
Russian Prime Minister Sergei Kirienko submits a budget austerity plan to the
IMF, which releases a previously held loan installment of $670 million.
Indonesia and the IMF announce a fourth agreement to rescue an economy
quickly sinking into chaos. The IMF agrees to restore subsidies for food and fuel

and provide another $4 billion to $6 billion for basic necessities.

July 1998:

 Russia's lower house of parliament, the Duma, postpones action on spending and
tax reforms needed to close the budget deficit and qualify for IMF loans.
Moscow's markets get pummeled as the government fails to raise cash by selling
government shares of a state-owned oil company. Moscow hints that an IMF loan
agreement is near.
President Clinton calls on the IMF to quickly conclude negotiations over
emergency loans for Russia after getting a call for help from Boris Yeltsin,
sparking a rally in Moscow's markets.
The IMF announces a package of $23 billion of emergency loans for Russia. The
international lender dips into an emergency line of credit to provide its share of
financing. Russian stocks and bonds soar.
Russia's Duma approves some of Yeltsin's $16 billion proposed tax reforms
needed to meet conditions for IMF loans. But it rejects higher sales and land
taxes.
Yeltsin vetoes tax cuts approved by parliament and issues decrees imposing a 3%
tax on imports and quadrupling land taxes to close the budget deficit and secure
IMF loans. He also pledges renewed efforts to collect taxes.
The IMF gives final approval to a $22.6 billion loan package to Russia. However,
because the Duma fails to enact some of the austerity measures mandated in the
loan agreement, the first two planned installments are reduced from $5.6 billion to
$4.8 billion.
The IMF announces that it will ease conditions on its $57 billion aid package to
South Korea which had been blamed for rising unemployment and overburdened

welfare programs.
August 1998:
Wall Street reacts to the deepening crisis; the Dow plunges 300 points in its thirdbiggest loss.
Amid speculation that China will be forced to devalue its currency, Hong Kong's
dollar and stock market come under attack.
The World Bank approves a $1.5 billion loan for Russia as Moscow puts pressure
on striking miners and tax deadbeats in an effort to put its finances in order.
Asian markets plummet as Hong Kong and China step in to defend their
currencies against attack.

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 The Russian market collapses. Trading on the stock market is temporarily

suspended. World markets are rocked by fears of a financial meltdown in Asia and
Russia.
Russia's markets collapse on fears that Moscow will run out of money and
default.
Russia announces a devaluation of the ruble and 90-day moratorium on foreign
debt repayment, triggering panic in Moscow as Russians line up to buy dollars.
Western leaders denounce the Russian default.
Latin American stock and bond markets plunge on fears of default and
devaluation in South America.
Russia fails to pay its debt on GKO or treasury bills, officially falling into default.
The IMF and Group of Seven (G-7) say they won't provide additional loans to
Russia until it meets existing promises.
Russia's economic crisis shakes world markets, bulldozing stocks and bonds in
Latin American and reverberating through the US and Europe. Russia's Duma
calls for Yeltsin's resignation. Investors pile into US Treasury bonds as a safe
haven from the storm, causing yields to drop to record lows.
Yeltsin dismisses Kirienko and names Viktor Chernomyrdin as primeminister.
After weeks of decline, Wall Street is overwhelmed by the turmoil in Russia and
world markets. The Dow Industrial average plunges 512 points, the second-worst

point loss in the Dow's history.

September 1998:
Federal Reserve Chairman Alan Greenspan says that the US is ready to cut
interest rates to keep the crisis from snuffing out US growth. "It is just not
credible that the United States can remain an oasis of prosperity," he says.
Latin stocks and bonds plummet.
Russia's Duma rejects Prime Minister-designate Chernomyrdin and the central
bank chairman resigns, deepening the country's political and economic turmoil.
Russian investors and lenders estimate their losses at $100 billion.
The Dow loses 249 points as Brazilian stocks fall 16%, adding to drops that have
erased half the Brazil market's value. In Mexico, the Central Bank sells some $50
million in its first attempt to buoy the peso in three years.
The IMF announces that the debacle in Latin American markets is "an
overreaction to Russian events" and that it is ready to lend Latin American
countries, using an emergency line of credit. Investors flee Brazil, drawing out
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more than $2 billion a day despite an interest rate rise to 50% by the Central
Bank.
Tokyo's Nikkei index hits a 12-year low amid steep declines in Hong Kong,
France, Britain and the US. The Dow drops 216 points. Congress blocks Clinton's
request for $18 billion in funding for the IMF.
Pushed by the New York Federal Reserve, a consortium of leading US financial
institutions provides a $3.5 billion bailout to Long Term Capital Management, one
of the largest US hedge funds, amidst fears that a collapse could worsen the panic
in the financial markets.
Stocks on Wall Street and in Europe swoon amid fears that the losses suffered by
the world's largest banks in the Long Term Capital debacle could put the entire
banking system at risk.
The Fed cuts interest rates by a quarter point.
Worries that the Fed isn't doing enough to rescue the US and global economies
cause a 238-point drop in the Dow, for a loss of more than 500 points in a week.
Investors around the world flock to US Treasury bonds for safety, causing the

yield on 30-year bonds to drop below 5% for the first time in three decades.
October 1998:
Japan announces a $30 billion aid for south east asia, to help the region to recover
from recession. G-7 ministers create a rescue plan for Brazil.
The Fed cuts interest rates for a second time to prevent weak financial markets
from tripping the US into a recession. The Dow shoots up 331 points and world
markets rally.
Amid warnings of winter food shortages in Russia, Moscow creates an emergency
food reserve and approves an emergency spending plan that will require the
central bank to print at least $1.2 billion to help pay back wages, rescue banks and
bring food to desperate regions.
Brazil's President Fernando Cardoso announces an austerity plan of $80 billion in
tax increases and spending cuts over three years in order to secure an IMF
assistance package.
The IMF refuses to disburse to Russia a $4.3 billion installment of the $22.6 aid
package it agreed to in July, and says it will not resume negotiations about

disbursement until Russia produces a realistic budget for 1999.

November 1998:

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 Russia strikes an agreement with foreign investors to accept repayment in rubles

of $40 billion of debt frozen in August, but says it will not be able to repay $17.5
billion of debts due in 1999 and will reschedule them. Russia also wins an $800
million loan from Japan, originally part of the IMF rescue deal.
The US agrees to provide 3.1 million tons of food to Russia to help offset Russia's
worst grain harvest in 45 years and declining food imports because of the fall of
the ruble.
The IMF, World Bank and leading industrial nations announce a $41.5 billion
rescue package for Brazil.
The Fed, citing "unusual strains" in the credit markets, cuts interest rates for a

third time in seven weeks.

December 1998:
The World Bank projects that the crisis has cut world growth in half, to around
2%, and that unless Japan reverses the decline of its economy, the world could fall
into recession in 1999.
Official studies report that 80 million Indonesians--or 40% of the population-have fallen below the poverty line since the start of the economic crisis.
In Brazil, the congress rejects a key social security tax increase sought by the
IMF, prompting a rout in Brazilian markets and stock sell-offs throughout Latin

America and on Wall Street.

January 1999:
The Brazilian government allows its currency, the real, to float freely on world
markets by lifting exchange controls. The move leads to a surge in markets in
Latin America and around the globe as investors buy up Brazilian stocks at
reduced prices.
Brazil's central bank raises interest rates in an effort to stabilize the market and to

stem capital flight which has reached $200 million to $500 million a day.
March 1999:
The IMF approves a $1 billion increase in its emergency loan package for
Indonesia. The fund also approves the release of a $460 million installment that it
had held back due to Indonesia's delay in closing down insolvent banks.
The Dow Jones Industrial Average closes above the 10,000 level for the first time
in its history.
The Dow Jones Industrial tops 11,000.

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Causes
The great debate on causes is whether the blame should be allocated to domestic policies and
practices or to the intrinsic and volatile nature of the global financial system. In the first phase of
the crisis, as it spread from Thailand to Malaysia, Indonesia, the Philippines, then to South
Korea, the international establishment (represented by the IMF) and the G7 countries placed the
blame squarely on domestic ills in the East Asian countries. They cited the ill judgment of the
banks and financial institutions, the over-speculation in real estate and the share market, the
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collusion between governments and businesses, the bad policy of having fixed exchange rates (to
the dollar) and the rather high current account deficits. They studiously avoided blaming the
financial markets, or currency speculation, and the behavior of huge institutional investors.
This view was difficult to sustain. For it implied that the "economic fundamentals" in East Asia
were fatally flawed, yet only a few months or even weeks before the crisis erupted, the countries
had been praised as models of sound fundamentals to be followed by others. And in 1993 the
World Bank had coined the term the East Asian Miracle to describe the now vilified economies.
However, there rapidly developed another view of how the crisis emerged and spread. This view
put the blame on the developments of the global financial system: the combination of financial
deregulation and liberalization across the world (as the legal basis); the increasing
interconnection of markets and speed of transactions through computer technology (as the
technological basis); and the development of large institutional financial players (such as the
speculative hedge funds, the investment banks, and the huge mutual and pension funds). This
combination has led to the rapid shifting of large blocks of short-term capital flowing across
borders in search of quick and high returns, to the tune of US$2 trillion a day. Only one to two
percent is accounted for by foreign exchange transactions relating to trade and foreign direct
investment. The remainder is for speculation or short-term investments that can move very
quickly when the speculators' or investors' perceptions change. When a developing country
carries out financial liberalization before its institutions or knowledge base is prepared to deal
with the consequences, the it opens itself to the possibility of tremendous shocks and instability
associated with inflows and outflows of funds. What happened in East Asia is not peculiar, but
has already happened to many Latin American countries in the 1980s, to Mexico in 1994, to
Sweden and Norway in the early 1990s. They faced sudden currency depreciations due to
speculative attacks or large outflows of funds. A total of US$184 billion entered developing
Asian countries as net private capital flows is 1994-96, according to the Bank of International
Settlements. In 1996, US$94 billion entered and in the first half of 1997 $70 billion poured in.
With the onset of the crisis, $102 billion went out in the second half of 1997. The massive
outflow has continued since. These figures help to show:
(i)
(ii)

how huge the flows (in and out) can be;

how volatile and sudden the shifts can be, when inflow turns to outflow;

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(iii)

how the huge capital flows can be subjected to the tremendous effect of "herd instinct,"
in which a market opinion or operational leader starts to pull out, and triggers or
catalyses a panic withdrawal by large institutional investors and players.

In the case of East Asia, although there were grounds to believe that some of the currencies were
over-valued, there was an overreaction of the market, and consequently an "over-shooting"
downwards of these currencies beyond what was justifiable by fundamentals. It was a case of
self-fulfilling prophecy. It is believed that financial speculators, led by some hedge funds, were
responsible for the original "trigger action" in Thailand. The Thai government used up over
US$20 billion of foreign reserves to ward off speculative attacks. Speculators are believed to
have borrowed and sold Thai baht, receiving US dollars in exchange. When the baht fell, they
needed much less dollars to repay the baht loans, thus making large profits. A report in Business
Week in August 1997 revealed that hedge funds made big profits from speculative attacks on
Southeast Asian currencies in July 1997. In an article titled "The Rich Get a Little Richer," the
business weekly reported on the profit levels of US-based "hedge funds", or investment funds
that make their money from leveraged bets on currencies, stocks, bonds, commodities.
According to Business Week, in the first half of this year, the hedge funds performed poorly. But
in July 1997 (the month when the Thai baht went into crisis and when other currencies began to
come under attack) they "rebounded with a vengeance" and that most types of funds posted
"sharp gains". The magazine says that a key contributing factor for the hedge funds' excellent
July performance was "the funds' speculative plays on the Thai baht and other struggling Asian
currencies, such as the Malaysian ringgit and the Philippine peso." As a whole, the hedge funds
made only 10.3 percent net profits (after fees) on average for the period January to June 1997.
But their average profit rate jumped to 19.1 percent for January-July 1997. Thus, the inclusion
of a single month (July) was enough to cause the profit rate so far this year to almost double.
This clearly indicates a tremendous profit windfall in July. In some countries, the first outflow
by foreigners was followed by an outflow of capital by local people who feared further
depreciation, or who were concerned about the safety of financial institutions. This further
depreciated the currencies.
Boom and bust in Asia

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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 3583% 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.

The main causes of the crisis can be attributed as follows:

Financial-sector weaknesses cum easy global liquidity conditions: More than anything
else, it was financial-sector weaknesses that got the Asian countries into deep trouble.
During the 1990s, each of the ASEAN 4 economies (Thailand, Indonesia, Malaysia, and
the Philippines) experienced a credit boom, that is, the growth of bank and non-bank
17

credit to the private sector exceeded by a wide margin the already rapid growth of the real
economy. The credit boom was stoked in part by large net private capital inflows, and
much of it was directed to real estate and equities. This overextension and concentration
of credit left the ASEAN 4 economies vulnerable to a shift in credit conditions. When
that shift came, induced by a need to control overheating and to defend fixed exchange
rates, it brought with it, inter alia, falling property prices and a rising share of nonperforming bank loans. Because the credit boom ended earlier in Thailand and Indonesia,
the effects were first visible there.

Vulnerability was also heightenedparticularly in Thailand and Indonesia (and later on

in South Korea)because banks and their corporate customers, in an effort to lower
borrowing cost, undertook most of their foreign borrowing at short maturities and in
foreign currency. These liquidity and currency mismatches eventually took their toll both
in motivating speculative attacks and in limiting the authorities' room for maneuver.

18

These financial-sector problems could not have progressed so far were it not for longstanding weaknesses in banking and financial-sector supervision. Loan classification and
provisioning practices were too lax; there was too much "connected" and "policydirected" lending; state-owned banks did not pay much attention to the creditworthiness
of borrowers; bank capital was often inadequate relative to the riskiness of banks'
operating environment; and there were strong expectations of government bailouts should
banks get into difficulties. On top of this, the quality of public disclosure and
transparency was poor.
Of course, it takes two (lenders as well as borrowers) to tango. It is well to recall that the
1990s were a time of bountiful global liquidity conditions, with over $420 billion in net
private capital flows going to Asian developing countries alone; spreads declined,
maturities lengthened, and loan covenants weakened. The presence of historically low
interest rates in Tokyo also gave rise to a large "carry trade," where funds could be
borrowed directly from Japanese institutions or intermediated via U.S. lenders. And much
like Mexico before its crisis, the ASEAN 4 countries were viewed as among the most
attractive emerging-market borrowers, with a history of rapid economic growth, high
saving and investment rates, disciplined fiscal positions, and growing integration with the
world economy.

External-sector problems: Most of the affected countries had run moderate to large
current-account deficits during the 1990s (in 1996, Thailand registered a current-account
deficit of about 8 percent of GDP). For quite a while, these external deficits were viewed
as "benign," since they did not result from large public-sector imbalances and since
foreign borrowing was being used mainly to increase investment (rather than
consumption). But in 1996 and 1997, concerns mounted on several counts.

19

For one thing, attention shifted from the quantity to the quality of investment. Too much
of the investment was directed at speculative activities, overextended industries, overambitious

infrastructure

projects,

and

inefficient

government

monopolies.

Competitiveness in the ASEAN 4 economies also seemed to be waning, as indicated, by

appreciations of real effective exchange rates (relative to a ten year trend), by sharp
slowdowns in merchandise export receipts in 1996, and by a perceived shift in regional
comparative advantage toward China. Moreover, the sustainability of Asian external
deficits seemed threatened by overproduction in certain industries (e.g., autos, memory
chips, petrochemicals, steel, wood products, etc.) and by intense export competition in
the region.

Contagion: The third contributing factor to the crisis was the contagion of financial
disturbances across countries. The Asian crisis is unusual in that it originated in a small
country (Thailand) and spread to a wider set of economies, including some larger ones.
In analyzing the channels of contagion, it seems unlikely that bilateral trade or investment
shares with Thailand could have been the driving force: these shares are just too small to
generate such wide-ranging contagion. Instead, two other channels are more plausible.
One is the "wake-up call" hypothesis. It says that Thailand acted as a wake-up call for
international investors to reassess creditworthiness of Asian borrowers and when they did
that reassessment, they found that a quite a few of these economies had weaknesses
similar to those in Thailand (that is, weak financial sectors with poor prudential
20

supervision, large external imbalances, appreciating real exchange rates, declining quality
of investment, etc.). The other major contagion channel results from the dynamics of
devaluation. As one country after another undergoes a depreciation, the countries who
have not devalued experience a deterioration in competitiveness, which in turn makes
their currencies more vulnerable to a speculative attack.
And as the number of countries affected by the crisis grew, other multilateral channels of
trade and capital flow interdependence also generated spillovers. For example, the
problems at Indonesia's banks and corporates have rebounded to the disadvantage of
Singapore's banks, the crisis-induced weakening of primary commodity prices has hurt
Chile's exports, and the difficulties experienced by Korean banks have had adverse
knock-on effects as far away as Russia and Brazil (since Korean banks were heavy
purchasers of both Russian GKOs and of Brazilian Brady bonds and liquidated much of
their holdings during the crisis).
The sequence of events leading to and worsening the crisis included the following:

Financial liberalization: Firstly, the countries concerned carried out a process of

financial liberalization, where foreign exchange was made convertible with local
currency not only for trade and direct investment purposes but also for autonomous
capital inflows and outflows (i.e. for "capital account" transactions); and where inflows
and outflows of funds were largely deregulated and permitted. This facilitated the large
inflows of funds in the form of international bank loans to local banks and companies,
purchase of bonds, and portfolio investment in the local stock markets. For example, the
Bangkok International Banking Facilities (BIBF) was set up on March 1993, to receive
foreign funds for recycling to local banks and companies, and it received US$31 billion
up to the end of 1996.South Korea recently liberalized its hitherto strict rules that
prohibited or restricted foreign lending, in order to meet the requirements for entering
the OECD. Its banks and firms received large inflows of foreign loans, and the country
accumulated US$150 billion of foreign debts, most of it private-sector and short-term. In

Indonesia, local banks and companies also borrowed heavily from abroad.
Currency depreciation and debt crisis: The build-up of short-term debts was becoming
alarming. What transformed this into crisis for Thailand, Indonesia and South Korea was
21

the sharp and sudden depreciation of their currencies, coupled with the reduction of their
foreign reserves in anti speculation attempts. When the currencies depreciated, the
burden of debt servicing rose correspondingly in terms of the local-currency amount
required for loan repayment. That much of the loans were short-term was an additional
problem. Foreign reserves also fell in attempts to ward off speculative attacks. The shortterm foreign funds started pulling out sharply, causing reserves to fall further. When
reserves fell to dangerously low levels, or to levels that could not allow the meeting of

foreign debt obligations, Thailand, Indonesia and South Korea sought IMF help.
Liberalization and debt: the Malaysian case: Malaysia also went through a process of
financial liberalization, with much greater freedom for foreign funds to invest in the
stock market, for conversion between foreign and local currencies, and for exit of funds
to abroad. The Central Bank however retained a key control: private companies wanting
to borrow foreign-currency loans exceeding RM5 million must obtain the Bank's
approval. This was generally given only for investments that would generate sufficient
foreign exchange receipts to service the debts. Companies were also not allowed to raise
external borrowing to finance the purchase of properties in the country. Thus there was a
policy of "limiting private sector external loans to corporations and individuals with
foreign exchange earnings" which enabled Malaysia to meet its external obligations from
export earnings. According to a private-sector leader, this ruling saved Malaysia from the
kind of excessive short-term private-sector borrowing that led the other three countries
into a debt crisis. As a result of these controls, Malaysia's external debt had been kept to
manageable levels. Nevertheless the debt servicing burden in terms of local currency has
been made heavier by the sharp ring it depreciation. The relatively low debt level,
especially short-term debt, is what that distinguished Malaysia from the three countries
that had to seek IMF help. The lesson is that it is prudent and necessary to limit the
degree of financial liberalization and to continue to limit the extent of foreign debt, and

moreover to in future keep the foreign debt to an even much lower level.
Local Asset Boom and Bust, and Liquidity Squeeze: The large inflows of foreign
funds, either as loans to the banking system and companies directly, or as equity
investment in the stock markets, contributed to an asset price boom in property and stock
markets in East Asian countries. With the depreciation of currencies, and expectations of
a debt crisis, economic slowdown or further depreciation, substantial foreign funds left
22

suddenly as withdrawal of loans and selling off of shares. Share prices fell. Thus the falls
in currency and share values fed each other. With weakened demand and increasing oversupply of buildings and housing, the prices of real estate also fell significantly.
For the countries afflicted with sharp currency depreciations and share market declines,
the problems involved;
The much heavier debt servicing burden of local banks, companies and
governments that had taken loans in foreign currencies,
The fall in the value of shares pledged as collateral for loans by companies and
individuals, and the fall in the values of land, buildings and other real estate
property. This has led to financial difficulties for the borrowers.
The higher interest rates caused by liquidity squeeze and tight monetary policies
have caused added financial burdens on all firms as well as on consumers that
borrowed;
As companies and individuals face difficulties in servicing their loans, this has
increased the extent of non-performing loans and weakened the financial position
of banks, and
Higher inflation caused by rising import prices resulting from currency
depreciation.
Moreover, in order to reduce the current account deficit, or in following the orthodox
policies of the IMF, governments in the affected countries reduced their budget
expenditure. The main rationale was to induce a reduction in the current account deficit,
which had been targeted by currency speculators as a weak spot in the economy. Added
to the higher interest rate and the tightening of liquidity, the budget cut also added to

recessionary pressures.
The fall in output: In the region, the financial crisis has been transformed to a full-blown
recession in the real economy of production. Worst affected is Indonesia with a 6.2% fall
in GDP in the first quarter 1998, and a newly projected negative growth for 1998 of 15%,
inflation of 80% and expected unemployment of 17% or 15 million. South Korea's GDP
fell 3.8% in the first quarter 1998. Thailand's 1998 GDP was expected to drop 4 to 5.5
percent in 1998. Hong Kong's GDP fell 2% in the first quarter. Singapore enjoyed 5.6%
growth in the first quarter but is expected to slip into negative growth sometime in the
second half of 1998. In Malaysia, real GDP fell 1.8% in first-quarter 1998 (compared to
6.9% strong growth in 4th quarter-1997). A bright spot for the region was a turnaround in
23

the current account of the balance of payments. However this improvement came with a
heavy price. The increased trade surplus was caused more by a fall in imports than by a
rise in exports, especially in real (or volume) terms. Thus the trade surplus indicates the
effects of recession on falling imports, rather than an expansion of exports. Another point
to note is that an improvement in the current account need not necessarily mean a healthy
overall balance of payments position unless there is also a positive development in the
capital account. A possible weakness here could be an outflow of short-term funds, by
either foreigners or local people. To offset this, a repatriation of funds owned bylocal

companies or people back to the country should be encouraged.

Easing of fiscal and monetary policy: Recently there has been an easing of fiscal and
monetary policy in the affected countries in response to the depth of the recessionary
conditions. These actions would hopefully have the effect of improving economic
conditions and ease recessionary pressures.

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 or because the intermediaries were owned by Ministers nephews.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
24

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 did it not occur before 1997?
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 shortterm 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.)
25

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.

Debate over the causes: The impact of the Asian financial crisis raised deep doubts about the
reigning ideology of financial globalization and the design of the international financial
architecture. The volume of literature and analyses on the root causes of the Asian crisis, and the
lessons that need to be learned, is extensive. Scholars and analysts debate a wide diversity of
arguments and counter-arguments, and thus, while popular perspectives abound across different
communities, there is no one single consensus on the causes of the crisis. Some experts
maintains that the crisis resulted from the fundamental weaknesses in the domestic financial
26

institutions of the affected countries. It is argued that the liberalization of domestic financial
markets was not accompanied by necessary levels of transparency and regulation. Corporate
financial structures in the region, too, it is argued, were riddled with governance problems such
as endemic corruption, the concentration of ownership, and excessive levels of government
involvement. The counter-argument emphasizes that the economic successes of the East Asian
economies belies the notion that they were dysfunctional economies. It is believed that the lack
of transparency and the weakness of financial systems do not necessarily lead to financial crisis
otherwise, what can explain the relative insulation from the Asian crisis for countries such as
China and India? In the years since the Asian crisis, many scholarly as well as popular
evaluations of the crisis have contended that international financial liberalization, characterized
by the free and rapid mobility of short-term capital, played the central role in instigating the
crisis. In the decade that preceded the onset of the crisis in mid-1997, East Asian economies had
moved toward financial liberalization, which can leave developing countries vulnerable to
financial speculation, sudden changes in the exchange rate, and surges in capital inflows, which
simultaneously increases the risk of capital outflows. This phenomenon, often referred to as hot
money, is a direct result of the intrinsically volatile international financial market. The salience
of financial liberalization is reinforced by the fact that the financial crises of the 1990sMexico,
Turkey, and Venezuela in 1994, Argentina in 1995, and the East Asian countries in 1997-1998
shared the element of sudden, unanticipated, and volatile shifts in global capital flows, which
resulted in deep economic contractions.

Lessons learned from Asian crisis

Financial globalization began to gain momentum following the debt crisis of the 1980s. In
Southeast Asia, financial globalization took shape in particular ways. The region was less
affected by the debt crisis than Latin America as Southeast Asian countries did not borrow
international capital as heavily in the 1970s, and thus, were not as vulnerable as Latin American
countries were. Nonetheless, the mid-1980s in Southeast Asia saw three devaluations in

27

Indonesia, a single devaluation in Thailand in 1994, and a depreciation of the Malaysian ringgit.
These devaluations were accompanied by other elements of domestic and international financial
liberalization.
The Asian crisis of the 1990s that began with speculative attacks on the Thai baht and spread
across Asia and other EMs remains vivid in our minds. The events as they unfolded are well
known, so this project focus on what Asian authorities did and what the rest of the us have
learned from those events.
The Asian authorities embarked on an ambitious and broad ranging program of economic and
financial sector reforms following the Asian Financial Crisis. These are:
First, there was wide recognition in Asia that stock problems, such as loans gone bad,
had to be dealt with early in the process. Failed institutions were closed while the
remaining viable banks were recapitalized and their legacy nonperforming loans
removed and sold to restore profitability.
Second, gaps were identified in regulatory and supervisory frameworks, and new laws
and institutions were introduced to fill them. A more proactive and intensive approach to
bank supervision was adopted. Risk management policies, including rules on corporate
governance and disclosure, were revamped with stiffer penalties for unsafe and unsound
banking practices and expanded supervisory powers to intervene and conduct regular
examinations. Many Asian economies also invested in modern market infrastructure to
ensure that the financial sector was able to cope with the demands of a rapidly growing
region. And authorities in many countries have instituted measures to encourage the
development of local currency bond markets, which have the effect of reducing the
double mismatch of currency and duration and to allow for further diversification of
funding sources.
Third, well ahead of the rest of the world, Asian authorities realized the value of macro
prudential policies to ensure financial stability. They routinely respond to emerging
systemic risks by deploying a variety of instruments, such as restrictions on loan-to-

28

value and debt-to-income ratios, limits on currency and maturity mismatches, and
adjustments in risk weights to contain excessive financial imbalances.
Fourth, the Asian authorities, especially in East and South East Asia, took significant
steps to reduce macroeconomic and external imbalances in the wake of the East Asia
crisis. These steps led to low inflation, more sustainable current account positions, and
low external debtall of which provided a sound basis for a robust economic expansion.
Fifth, exchange rate regimes were made more credible and resilient. Most significantly,
many countries allowed their currencies to depreciate during the global crisis, sometimes
by large amounts, cushioning the blow of capital outflows. However, letting the
exchange rates go as a line of defense was not an easy option during the Asian crisis due
to unhedged foreign borrowing and low international reserves.
Finally, Asia re-established policy credibility with clear communication of realistic
policy goals and a track record of achieving them.
The reforms that followed the Asian Financial Crisis continue to help Asia today. Since yeasr,
many countries have used the buffers they built in good times and deployed a mix of exchange
rate depreciation, external reserves, and higher interest rates to face the tightening of global
financial conditions following the Feds announcement of tapering its asset purchases. Of
course, individual country circumstances have mattered-some countries, such as India and
Indonesia, with large macroeconomic imbalances, have faced some difficulties. Importantly,
though, the decisive response of the authorities has clearly helped calm financial markets.
Lessons That Live On
Voices from around the world have pronounced a wide gamut of lessons that the crisis presented.
One of the most widely discussed lessons in the international community is the imperative to
build a new international financial architecture. Such a new architecture would ensure the
efficient allocation of capital, manage free capital mobility, provide financial safety nets, address
information asymmetries, and prevent herding in the financial markets. The goal of this new
architecture is to improve the tradeoff between financial liberalization and financial stability, and

29

thereby prevent financial crises or help resolve them at the lowest possible cost should they
occur. The fundamental lesson that has been reinforced in various global forum are:

Large capital inflows can potentially have a destabilizing impact on the recipient
economy, particularly when the local currency is convertible. Short-term capital inflows,
in particular, are inherently volatile in a world of free capital mobility, and can trigger
losses in investor confidence that can result in large losses in foreign reserves and
currency depreciation. Thus,excessive reliance on external capital needs to be avoided

through a cautious management of capital inflows.

The dangers associated with capital market liberalization are one of the most important
lessons of the Asian crisis, pointing out that it was not an accident and that the only two
major developing countries to be spared from crisis were India and China. Both had

resisted capital market liberalization.

The Malaysian experience during the Asian crisis highlights that developing countries
that have liberalized their financial sector can still manage their capital flows through
certain policy tools, such as selective capital controls or regulations to discourage or

prevent speculation.
The crisis-affected Asian countries also learned a critical lesson through their loan
programs with the IMF. The Fund provided more than $100 billion in emergency funds
to Thailand, Indonesia, and Koreathe three worst-hit countrieswith the goal of
restoring investor confidence and ameliorating the economic crisis. However, rather than
achieving their stated goals, the Funds programs seemed to accelerate capital flight.
It is argued that the IMFs inappropriate focus on overhauling financial institutions in
the heat of the crisis worsened investor confidence by re-emphasizing domestic financial

weaknesses.
The IMF loan programs demonstrated how the high interest rates prescribed by the Fund,
and intended to curtail currency depreciation, induced a severe credit crunch that
exacerbated the financial dilemmas of local banks and firms and had a sharp deflationary
effect on domestic economic activity.

Reforms considered post crisis

30

Among these kinds of risks that might persist or new risks that might emerge are potential
unwanted side-effects from the mix of policies used to support recovery after the crisis, or risks
associated with only incomplete implementation of reforms
The major issue of the crisis-affected economies is how to manage vulnerability and reduce risk
of further crisis. Two broad strategies have been pursued. First, because of exchange rate
depreciation, these economies have generally been able to run current account surpluses and
build up foreign exchange reserves as a buffer and insurance policy against future crises .
Second, they have sought to strengthen fundamentals.
As the Asian crisis resulted from massive capital inflows, which caused these countries to be
excessively exposed to massive short-term foreign liabilities, one can point to the need for a
prudent macroeconomic policy with reliable policy instruments in place.
Rethinking Capital Controls
Many emerging economies face greater risk of sudden capital inflows and outflows, the
consequent pressure on exchange rates and undesirable effects on domestic financial institutions.
The best protection against capital account crises and contagion would be to strengthen the
international financial institutions and the domestic policy frameworks. However, these
improvements at the international and domestic front may not be able to be achieved overnight,
thus rendering domestic financial markets vulnerable to external shocks.
The Malaysian experience on capital controls appears to have had a salutary effect, mainly
because controls were supported by a sound macroeconomic policy framework, bank and
corporate restructuring, an undervalued currency, credit supervision and time-bound measures.
The hard peg is a credible commitment to the fixed exchange rate, such as the currency board
of Hong Kong or in the extreme, a full dollarisation of the economy. Under these conditions,
monetary policy becomes passive.
Favourable external environments have also undoubtedly helped Malaysia to recover from the
crisis. Also, Malaysian controls on short-term capitals had been justified in the transition period
as financial safeguards, and these measures had been introduced just in time before the crisis
fully erupted.
The Malaysian case suggests that deployment of capital outflow controls should not be rejected
categorically. However, capital outflow controls are temporary measures and can have a negative
31

impact on future capital inflows. This might hamper future economic growth, especially when
there is a negative impact on FDI.
Appropriate Exchange Rate Regime
Debate over exchange rate regime, after the Asian crisis, is not about fixed versus flexible
exchange rates. Rather, it has been reformulated with respect to the new question of which
monetary system or which exchange rate system would be the best one to achieve price stability.
However, as one could easily imagine, economists are still having opposing views. This is
because a large number of monetary authorities face an impossible trilemma of simultaneously
achieving exchange rate stability, full financial integration and monetary policy independence
otherwise known as the unholy trinity, by Mundell-Fleming.
For reasons, it has been argued that if a country attempts to achieve exchange rate stability and
monetary policy independence, it needs to introduce capital controls. If a country attempts to
promote full financial integration and monetary policy independence, it needs to adopt a flexible
exchange rate regime. If a country attempts to achieve exchange rate stability and full financial
integration, a very rigid exchange rate such as the currency bound or a currency union can only
be achieved by abandoning monetary policy independence. As a result, it has become more
difficult for the Asian emerging economies to single out the most appropriate exchange rate
regime under capital account liberalization.
Strengthening the Financial Sector
A lesson learnt from the Asian crisis is that financial institutions should be supervised and
regulated adequately, since financial openness deepens the impact of domestic weaknesses
because international and domestic investors can take their money out. Financial globalization
exposes crisis-hit countries to the irrationality of international markets, which invite twin crises
and serious contagion. Also, the existence of weak domestic financial institutions reduces the
central banks ability to use the domestic interest rate as a macroeconomic tool and is likely to
amplify the twin crises.
In general, it has become clear that transparency in the financial sector, in particular its financial
operations, is important to build confidence and reduce the possibility of speculative attacks
driven by asymmetric information among investors. The fact that financial market participants do
32

not have equally good information about their customers means that banks have no choice but to
raise funds even in a crisis thus causing further damage to their balance sheets. Since banks
conduct transactions with each other, problems in one bank create problems in others. This
induces a situation in which a sudden loss of depositors confidence produces a system-wide
panic or systemic risk.
AMF Proposal (Asian monetary fund)
The Asian crisis showed that Asia cannot depend on the IMF. With this lesson in mind, Japan
proposed in 1997 to establish the AMF to supplement the IMF role for macroeconomic and
financial surveillance and for providing policy dialogue as well as for pooling resources at the
regional level.17 The idea is that the AMF would act more quickly and appropriately than the
IMF. However, the timing for submitting such a project was not right. The US, Europe, the PRC
and the IMF strongly opposed it and forced Japan to drop the proposal.
As often pointed out by economists, it is necessary for creditors to speak with one voice during
the crisis. The AMF would provide different conditions of assistance from the IMF
conditionality. Such a different opinion among creditors creates incentives for debtors to play
one against the other. As consolation for the withdrawal of the AMF proposal, a number of
leading emerging countries in East and Southeast Asia were invited in 1999, to join world forum
such as BIS and G-20 as well as several committees of the IMF. Their participation in these
activities might help them to learn the rules of the game for globalization as well as to inject
the Asian input to the forum.
Exchange Rate Arrangements
Presently, East and Southeast Asian nations adopt a variety of exchange rate management
systems. However, in reality, most countries in the region still peg their exchange rates to the US
dollar. Prior to the crisis of 1997, Indonesia and South Korea had adopted a managed floating
exchange rate management, but still restricted their currency movement to the US dollar,
whereas Thailand maintained a strict pegging. Under the IMF programme, exchange rate policies
in Indonesia, South Korea and Thailand shifted to independent floating, supported by inflation
targeting as a monetary policy strategy. Along with the control of short-term capital movements,
Malaysia moved from managed floating to a strict pegging. Cambodia and Singapore maintain

33

the managed floating system; Myanmar, Vietnam and China preserve strict pegging while Brunei
and Hong Kong have adopted the currency board system.
Since then, new proposals to achieve the exchange rate stability includes pegging regional
currencies to the yen, establishing a basket system for setting currencies and cooperation to help
one another defending the exchange rate regime of its choice by creating Asian exchange rate
mechanisms. In the long run, Asia might adopt a single Asian currency. Other argue that it is
difficult to go in that direction as the world is largely a US dollar standard. Therefore,
formalising East Asia to become part of the US dollar standard promotes exchange rate stability
and therefore solves the problem of crisis-prone economies, which was the root of the Asian
crisis in 1997

Conclusion

34

The 1997 crisis transformed the policy milieu in the region in ways that would have been
unthinkable years before. What was once considered dispensable, and even harmful, suddenly
became a vital component of development. The World Bank and IMF, as well as Asian leaders,
recognized the acute need for robust social welfare institutions. The President of the World Bank
was reported as saying: In the end the issue of social security and the issue of the impact on the
people are the only issues which matter. You can fix the relationships of some of the financiers
but if you do not follow through and think of the implications on the social sector
you have nothing save perhaps revolution and social unrest. (Wolfensohn, 1998). Recognition
of the need for social protection was one of the more positive outcomes of the 1997 crisis, as
governments in the region began to realize that economic growth alone was no panacea for
ensuring human development.
In retrospect, the steep deterioration in economic and social conditions triggered by the 199798
crisis could have been significantly avoided if there had been a social protection system in place
to cushion the blow. Without it, governments and international organizations had to hurriedly
establish new initiatives and expand existing programs under difficult circumstances marked by
lack of experience, information, and financial resources. While few formal policy evaluations of
the social protection programs launched during the crisis have been carried out not least due to
lack of reliable data it is possible to identify measures that appear to have worked. The impact
of public works programs was also positive in that they helped reduce the shock of the decline in
income .Public hospitals in Malaysia and Thailand, and public schools in Malaysia, also stand
out as institutions that continued to provide needed services, despite strains imposed by increased
demand, and thus prevented deterioration of the populations health and education status.
Unemployment insurance in South Korea was too new at the time the crisis erupted to have
provided substantial protection, underlying the importance of social assistance during times of
crisis. Looking forward to the current and future crises, what nations need is a general social
protection system that automatically comes into play to offer assistance in the event of
widespread decline in income, regardless of the cause, scope, and depth of the crisis. Thus,
instead of launching new social protection programs each time there is a financial, energy, or
food crisis, there should be affordable programs in place before crises erupt. Notwithstanding
widespread perceptions to the contrary, social protection is affordable to all countries, even the
poorest. According to ILOs projections for a sample of 12 low-income countries in Africa and
35

Asia, governments can establish social protection programs offering universal basic old age and
disability benefits at the cost of between 0.6 and 1.5% of annual GDP (ILO Social Security
Department, 2008). For perspective, note that the fuel subsidy in Indonesia at its height cost the
government nearly 4% of GDP. In comparison, the Bolsa Familia program in Brazil reached 11
million households and cost the government only 0.5% of GDP in 2006. Core elements of all
social protection systems should include free and compulsory primary education, access to
secondary education that is affordable to all, and free or low-cost access to basic health services.

36