2.

0 THE CAUSE OF 1997/98 ASIAN ECONOMIC CRISIS

In economic theory, the term crisis was used in the objective sense in the
late 17th century to refer to conditions of general market disequilibria. Economic
crises are turning points in the process of social reproduction as a whole. In the
neo-orthodox Marx theory, crises are creative ruptures in the continuity of the
reproduction of social relationships which lead to their restructuring in new forms.
Generally, economist agree that the Asian currency or financial crisis began in
Thailand in July 1997. However, many economists are still divided on what really
triggered the crisis. According to the Asian Development Bank (ADB) Report
(1999), two economic views dominated the debate on the causes of the crisis.
According to one view, it was poor economic fundamentals and policy
inconsistencies that caused the crisis. The other view argues that Asia fell victim to
a financial panic, where negative sentiment assumed a self-fulfilling prophecy.
According

to

fundamentalists,

serious

structural

problems,

regulatory

inadequacies and close links between public and private institutions caused the
Asian crisis. Malaysia wanted to retain the advantage of its achievements in
economic stability, but it was no easy task, especially because of the international
economic policies had assumed political overtones. The high performance of the
Malaysian economy that was maintained over the decades. However, in 1997 the
financial crisis came to light, and essentially being a short-term phenomenon, it
caused the crash of the Malaysian economy. Since the crisis in Asia erupted, a
variety of explanations have been offered for its causes. If the crisis is essentially
expectational in nature and unrelated to economic fundamentals a short term
panic then restoring confidence could have lead to a reversal of the asset
market declines.

Among the factors that caused the financial crisis in Malaysia were
investment rates, efficiency and profitability, deficiencies in risk management,
foreign debt and the role of short-term debt, misinformation that was given to the
public and foreign investors and the, liberalisation of financial markets and the last
cause that is panic and contagion.

2.1 INVESTMENT RATES, EFFICIENCY AND PROFITABILITY

First and foremost, the cause of economic crisis was from investment rates,
efficiency and profitability. Since the current account is the difference between
national savings and investments, a deficit can arise from either a decrease in
savings or an increase in investments. Conventional wisdom holds that borrowing
from abroad is less problematic if it is used to finance new investment rather than
consumption. Underlying such conventional wisdom is the assumption that the cost
of the borrowed funds is less than the profits made from the investments. Also
implicit in the assumption is that high investment rates contribute to the increase in
productive capacity in the traded sector. If the borrowed funds are invested in nontraded sectors (like property and construction) the chances of the funds producing
high profits is less, which may contribute to the current account deficit. The Asian
countries were characterised by very high rates of investment throughout the
1990s. Corsetti et al (1998a) believe that there are several reasons why such high
investments should be regarded with concern in regards to current account
sustainability. Evidence on the profitability of investment is provided by a standard
measure of investment efficiency known as the incremental capital output ratio
(ICOR), defined as the ratio of the investment rate and the rate of output growth.

2.2 DEFICIENCIES IN RISK MANAGEMENT

Besides, the deficiencies in risk management is one of the financial crises
had affected Malaysia; with huge mismatches between the asset and liabilities of
enterprises, leading them to assume excessive liquidity, interest rate and currency
risks. The currency mismatches had also happened in Malaysia, with the exchange
control regime requiring approvals for foreign currency borrowing. Several
prominent corporations were allowed to raise foreign currency loans, although they
only had ringgit cash flows. Due to the sharp ringgit depreciation, these
corporations were faced with massive foreign exchange losses or insolvencies
because of their currency mismatches and inabilities to hedge exposures. The
adverse consequences of these structural and policy distortions were crucially
magnified by the rapid process of capital imbalance. Moreover, the sharp
appreciation of the US dollar relative to the Japanese yen and European currencies
since the second half of 1995 led to deteriorating cost competitiveness in most
Asian countries whose cumulative effects appeared quite vulnerable to financial
crises either related to sudden switches in market confidence and sentiment, or
driven by deteriorating expectations about the poor state of fundamentals.
Moreover, the banking system in Malaysia was very risky and this caused bad
macroeconomics. The high risk nature of banking in distinction to fund
management had risen from its high gearing and massive asset liability
mismatches, and in particular, from its tendency to borrow for a short period and
lend for even longer. The overdependence on banks in Asia was caused by their
over-protection, as well as by the over-regulation of capital markets, and had also
affected the Malaysian financial system. This had caused the under-development of
non-banking financial institutions, capital markets, and risk management products,
risk intermediaries, trading and market-making, which had functioned under

inconsistent macroeconomic policies.

2.3 DEBT
Next, the cause are foreign debt and the role of short-term debt. A country
may suffer a short run liquidity problem if the available stock of reserves is low
compared to the overall burden of external debt service. Liquidity problems arise
when a country suffers from huge withdrawals of credit, so if a large fraction of a
countrys external liabilities are short-term a crisis may arise due to a liquidity
shortfall (Corsetti et al 1998a). When looking at IMF statistics, one does not get the
feeling that Asias short-term debt as a percentage of total debt indicates economic
vulnerability. In 1993 the average for the East Asian countries was 28% and by
1996 it only rose modestly to 33. For 1993 the average for the East Asian countries
was 98% of foreign exchange reserves, which is already quite a high figure.
However the numbers become even scarier when looking at the mid-1997 data,
with an average 140% of foreign exchange reserves. If a liquidity crisis occurs
foreign reserves must be large enough to cover a countries debt service.
2.4 MISINFORMATION
Furthermore, the financial crisis deepened because of misinformation that
was given to the public and foreign investors. There were at least two sources of
misinformation on the financial crisis. The first was the foreign media who
questioned the strength of the economy and the leadership of individual nations.
The second was the investors who perceived all East Asian economies as identical
and facing similar problems of the same magnitude. It is a result of these
misconceptions that market confidence was affected. Thus, there is yet to be an

international consensus on the actual cause of the crisis. Moreover, both economic
views happened to originate from the West and were viewed as a western diagnosis
of the already jealous Asian economies. From the Asian perspective, the possible
motives were not too difficult to imagine considering the speed at which Asia was
growing. The region appeared to be on its way to dominate the world
economically. Whether Asia would have eventually threat to western hegemony. A
major geo-economics and the emergence of China as a world power, geo-political
shift were changing the status quo. East Asian nations had not merely become
economic powerhouses, but also economic threats, particularly to the worlds sole
superpower, the United States. These political economic threats caused the Asian
financial crisis.
2.5 LIBERALISATION
Liberalisation of financial markets are the cause of economics crisis when
during the early 1990. Many of the East Asian countries liberalised their financial
markets. Proponents of this theory believe that had the Asian governments
continued with their state guided form of capitalism the crisis would not have
occurred. They also believe that liberalisation would have been a possibility had
the governments applied prudent regulation and supervision to the financial
systems. Liberalisation gave opportunities for foreign investors to allocate their
funds into East Asian countries and many of the funds were in the form of shortterm dollar denominated debts.
2.6 PANIC & CONTAGION
Last but not least, panic and contagion has been include in the causes of
crisis economic. There are has third theory on why the crisis happened was panic.
It is important to think about the meaning of the word crisis and panic and see how

they are linked to each other, with respect to financial market fluctuations. In the
case of a debt crisis, a financial panic can arise when individual creditors are
unwilling to rollover a loan because of the concern that a borrower will be unable
to fulfill its debt obligation with world financial markets can increase an
economys vulnerability to runs. According to Frankel and Rose (1996) a crisis is
defined as a rapid depreciation of a currency by at least 25%. This means that
whatever theories there are concerning the crisis, they have to do more than
explain the downturn of market indicators and exchange rates values. Contrary to a
recession a crisis is a large devaluation in a short space of time. Section 3 analyses
East Asian relationship-based capitalism and provides an explanation as to why the
crisis happened.
In a nutshell, the fourth prime minister of MalaysiaDr Mahathir Mohamad
once said: The country and the government were completely unprepared to deal
with the seriously deteriorating economy in July 1997. But government leaders
quickly identified currency traders and short-term investors as the culprits
responsible for the turmoil. But knowing who were responsible for the turmoil was
not enough. It was necessary to understand how they operated and how to counter
their attacks on the Malaysian economy. Therefore, by knowing the causes of
1997 and 1998 Asian Economic Crisis with particular emphasis on Malaysia,
Malaysians experience will provide invaluable lessons to other countries which
might face similar situations.