1997 Asian Financial Crisis

Introduction

The collapse of the Southeast Asian economies which began in the middle of 1997 was not accurately predicted by anyone. Indeed before the Asian financial crisis the mystery for economists was explaining how the Asian "tiger" economies had grown so quickly and consistently for so long. Instead the question now facing economists is why and how the economic collapse took place.

It is likely that the problems which led to the crisis were primarily structural rather than cyclical or an outcome of international financial problems, ie that the crisis was a result of the weak structure of certain Southeast Asian economic systems which had grown so quickly for so long that policy problems went unnoticed due to the confidence of such success. This page looks at what happened, the social and economic effects of the crisis, why it happened, and some of the policy issues and implications.

What Happened During the Asian Financial Crisis

"'It all began in Thailand' summarizes the conventional explanation of the early stages of the crisis." (Hill 1998, p.262) Thailand was the trigger that began a domino effect due to the interdependence of the Southeast Asian region.

The major factors in Thailand's downfall were structural such as Thailand's commitment to a fixed exchange rate and premature financial liberalization. In the early 1990s the Bank of Thailand began to relax restrictions on the economy by opening its capital account. This policy, combined with Thailand's exchange rate being fixed to the U.S. dollar alone, resulted in rapid expansion of the financial industry. The Bank of Thailand was unable to regulate the industry and hence the baht was floated on 2 July 1997 and began to fall sharply.

In Malaysia the major problems were also structural. Thailand's economic problems had led to a crisis of confidence among international investors. This led to the devaluation of the Malaysian ringgit and to overseas investors selling shares and abandoning Malaysia. However, it should be noted that this collapse in confidence occured after the crisis had begun rather than being an initial reason for the crisis.

Indonesia at first seemed to handle the problems much better than Thailand. However, the weak structure of Indonesia's economy eventually lost out. Corruption and cronysim had developed under President Soeharto compounded with the general loss of confidence in the region. From the annual World Bank report of 1998:

"Indonesia is in deep crisis. A country that achieved decades of rapid growth, stability, and poverty reduction is now near economic collapse. No country in recent history, let alone one the size of Indonesia, has ever suffered such a dramatic reversal of fortune."

In January 1998 the rupiah went into freefall. At one point it had depreciated to one sixth of its value before the crisis. And on 21 May President Soeharto resigned following political turbulence. If the structure of Indonesia's economy and policy had been more sound they would've likely been able to withstand the crisis in confidence better and their economy would not have suffered so much as a result.

The Effects of the Asian Financial Crisis

Indonesia has been by far the worst affected economy. In 1998, the economic growth of Indonesia was -15%, with Thailand the next worst affected at -8%, followed by Malaysia at -5.8%. The inflation rate of Indonesia has also been a very serious problem reaching 75% in 1998.

In terms of exchange rates, Indonesia has again been the worst affected. Between 1 July 1997 and 15 September 1998, the baht decreased by 78% against the U.S. dollar. All of the other major Southeast Asian economies also experienced currency depreciation, in particular Thailand with -42% against the U.S. dollar over the same period of time, Malaysia with -34%, the Philippines with -40%, and Korea with -36%.

The social impact of the crisis has been very similar to the economic results, with Indonesia again being by far the worst affected. The urban poor of Southeast Asia in particular have been hard hit by the increases in poverty, unemployment, and malnutrition. Millions of Southeast Asians have experienced significant declines in living standards.

However, rural producers have been significantly less impacted by the crisis. "Agriculture has been the strongest performing sector in the crisis economies; it is less exposed to the modern financial system; food crop production has been boosted after the El Nino induced drought broke in the region during the second quarter of 1998; and export-oriented cash crops have benefited from the currency depreciations. Rural producers have thus far escaped relatively unscathed, which is an important consideration since more than 40% of the workforce in both Indonesia and Thailand is still in agriculture." (Hill 1998, p.265)

Why the Asian Financial Crisis Happened

The major causes of the crisis include flaws in the Asian economic development model, the development of an international lack of confidence in Southeast Asian economies, the interdependence of the Southeast Asian economies which created a domino effect, fixed or quasi-fixed exchange rates, and other structural problems which produced generally shaky financial systems.

"The Asian economic model as it has developed historically, contributes to economic risk. It is not tranparent, and it lacks the controls which regulate growth in market economies. The model may contribute to political instability as well as economic instability in times of trouble. This is because so much is concealed and protected that it tends to lead to a crisis in confidence, and to simplistic solutions such as removing elite politicians from power, rather than addressing the fundamental weaknesses of the system." (Kitley 1998, p.3)

A fundamental problem with the Asian development model is that it relies so heavily on centralization of power and decision making. This has likely been a major factor in causing the crisis as it has placed too much control in the hands of a few people, such as politicians, who may put their own needs above the needs of the economy. Hence, this structural flaw has resulted in corruption, investment in non-performing sectors, the model being wrong about picking winners, promotion of the export sector at the cost of the domestic sector, and the development of crony capitalism. Crony capitalism inhibits the free market since state institutions favour certain capitalists for their own personal gain by granting loans, establishing monopolies, restricting imports, and other anti-competitive acts. This was especially prevalent in Indonesia under the Soeharto regime.

Although there was definitely international factors in the crisis it is likely that these were secondary and that the structure of certain Asian economies were the primary cause. The greatest international factor was a loss of confidence in the region by overseas investors. This certainly contributed to furthering the crisis, however it is likely that the loss in confidence was triggered by the crisis itself and then snowballed the problem rather than being an initial cause. For example, overseas investors started selling shares and abandoning Malaysia only after Thailand's economy started to collapse.

For the Southeast Asian economies to recover from the crisis, the flaws in the Asian economic model must be reformed and the region must regain the confidence of the overseas sector by addressing policy problems.

Policy Issues and Implications of the Asian Financial Crisis

Three major issues need to be considered with regards to the future of the Asian crisis: exchange rate policies, financial regulation, and economic cooperation of the region.

Exchange rate policies of the economies of Southeast Asia are a structural issue. "The policy regime that most Southeast Asian economies have maintained for the past decade (and longer in some cases) - fixed but adjustable exchange rates together with a fairly open capital account - is not sustainable. Countries therefore either have to close their capital accounts significantly or, in the presence of an open capital account, choose between a floating and a fixed rate." (Hill 1998, p.269)

The second policy issue is of financial regulation. The flaws of the Asian development model such as corruption and crony capitalism need to be addressed and reformed. "There is a general consensus among contributors that weak and poorly regulated financial systems are at the heart of the crisis." (Hill 1998, p.270)

Lastly, the interdependence of the Southeast Asian economies means that the region must cooperate in recovery from the crisis. ASEAN has of course been weakened by the crisis and hence the major initiatives for recovery have come from outside the region (for example, the International Monetary Fund). However, ASEAN needs to regroup and hold together to assist in the recovery of the region.

Conclusion

In conclusion, the Asian financial crisis was generally caused by the flaws of the Asian economic model, a crisis of confidence in Southeast Asian economies which was compounded by the interdependence of the region, poor exchange rate policies, and weak financial systems. "The crisis is not seen as a natural outcome of economic growth. The crisis is understood as the symptom or outcome of badly managed and badly structured economic systems. Time will not heal problems of this nature: radical restructuring is necessary." (Kitley 1998, p.5) Hence the policies of exchange rates, financial regulation, and economic cooperation need to be looked at for the future.

It should also be noted that the major factors are structural and therefore the Asian financial crisis is more than just a naturally cyclical response to the phenomenally consistent growth in the past of the tiger economies. Also, it is noted that there were international factors at play but that these were secondary and came into effect after certain economies had already begun to collapse because of problems with their economic structure. The crisis has demonstrated the problems that developed in some Asian economies during their huge periods of growth and shows the need for restructuring.

References

Hill, H. 1998, "An overview of the issues", ASEAN Economic Bulletin, vol. 15, no. 3, pp. 261-71.
Kitley, P. 1998, "The Asian Crisis", unpublished paper, pp. 1-15.
Athukorala, P. 1998, "Swimming against the tide: Crisis management in Malaysia", ASEAN Economic Bulletin, vol. 15, no. 3, pp.281-89.
Cole, D.C. & Slade, B.F. 1998, "Why has Indonesia's financial crisis been so bad?", Bulletin of Indonesian Economic Studies, vol. 34, no. 2, pp. 61-6.

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