WHAT CAUSES THE ASIAN FINANCIAL CRISIS?

The Asian Financial Crisis in 1997 was an unprecedented event. It has led to capital inflows
slowed or reversed direction, and growth slowed sharply which sees banks came under
significant pressures, investment rates plunged, and some Asian countries entered deep
recessions, producing important spill overs to trading partners across the globe (Carson and
Clark, 2000). South Korea, Indonesia and Thailand were the countries most affected by the
1997 financial crisis. In Indonesia, the fourth most populous country on earth, the impact was
shattering. In 1998, the economy contracted by nearly 14 per cent. South Korea's economic
reversals surpassed anything since the Korean War of the early 1950s. Thailand and
relatively affluent Malaysia experienced an abrupt reversal of long term growth trends. Chin
and Jomo described Malaysia as once considered by the World Bank (1993) as an
impressive example of successful development transformed from an economic ‘miracle’ into
a ‘debacle’ in 1997 (Chin and Jomo, 2000). Even Hong Kong and Singapore, the wealthiest
and most sophisticated economies in Asia outside Japan, suffered deeply as their trading
partners fell into crisis (Noble & Ravenhill, 2000). It was a complex combination of domestic
and international factors, to an extent difficult to clearly understand until today according to
some analysts (Pablo, 1998).

How do we explain the causes of the crisis? In general, this article aims to provide an
underlying causes of the crisis.

The market dependency on U.S. dollars is the one of the cause of the crisis at that
time. Many Asian countries had pegged their currencies to the U.S dollar at fixed exchange
rates. As the U.S dollar appreciated, these currencies became overvalued, making their
exports products became more expensive and less competitive internationally.
Governments, especially in developing economies, seek to manage exchange rates to
balance their ability to pay debts denominated in foreign currencies. Because investors
generally prefer instruments denominated in more stable currencies, governments in
developing economies often raise funds by issuing bonds denominated in U.S. dollars,
Japanese yen, or euros.

However, if the value of the domestic currency falls vs. the currency in which its debt is
denominated, that effectively increases the debt, as more local currency is needed to pay it.
So, when the Thai baht lost half of its value in 1997, that meant local borrowers needed
twice as many baht to pay debts denominated in U.S. dollars. As many developing countries
also rely on imports, a higher-valued local currency also makes those imports cheaper in
local currency terms. Conversely, governments may seek to keep their exchange rates low
to increase the competitiveness of exports, for example the case of Plaza Accord. The Plaza
Accord was a 1985 agreement among the G-5 nations—France, Germany, the United
States, the United Kingdom, and Japan—to manipulate exchange rates by depreciating the
U.S. dollar relative to the Japanese yen and the German Deutsche mark (Chen, 2021).
The countries had international trading and did several economic activities by using the U.S.
dollar. The domination of U.S. dollar in all sectors really influence the exchange rate of
currency (Radelet & Sachs, 2000). The initial financial turmoil in some Asian countries in
1997 and its propagation over time mainly to sudden shifts in market expectations and
confidence followed by regional contagion (Radelet and Sachs 1998; Marshall 1998; and
Chang and Velasco 1999). As for example, a decline in Thailand's exports caused investors
(domestic and foreign) to lose confidence that the government could maintain the pegged
exchange rate between the Thai baht and the U.S dollar. Fearing not only that the dollar
value of their investments would be reduced substantially, but also that the Thai government
would lack sufficient foreign currency reserves to meet all claims. Although the government
initially attempted to preserve the value of the baht by intervening in foreign exchange
markets, Thailand's foreign exchange reserves were soon exhausted. The government
consequently had no alternative but to allow the market to determine the currency's value,
and to seek emergency assistance from the IMF.

In addition, as Nambiar explains the case for Malaysia, Bank Negara Malaysia (BNM) tried,
unsuccessfully, to defend the ringgit in mid-1997. Following the sharp depreciation of the
Thai currency, the exchange rate of the ringgit fell dramatically. In March 1997, the ringgit
was valued at 2.48 against the United States dollar. Following the speculative attacks in
July, the ringgit dropped to about 2.57. By the end of 1997 the exchange rate fell to 3.77. By
January 1998 the ringgit had fallen to 4.88 against the United States dollar (Nambiar, 2003).

While admitting the worsening of the macroeconomic performance of some affected

countries in the mid-1990s, this view suggests that the extent and depth of the crisis should
not be attributed to deterioration in fundamentals, but rather to panic on the part of domestic
and international investors.

The second identified causes is due to excessive borrowing (Bustello 1998). Prior to the
crisis, there was a rapid inflow of foreign capital into Asian countries, driven by high interest
rates and favourable economic conditions. This led to excessive borrowing by governments,
corporations, and individuals, creating a large amount of debt. During the time, Asian
countries economic growth were miraculously unwavering somehow unexpectedly
concealing a serious vulnerabilities. In particular, domestic credit had expanded rapidly for
years, often poorly supervised, creating significant leverage along with loans extended to
dubious projects. Rapidly rising real estate values (often fuelled by easy access to credit)
contributed to the problem, along with rising current account deficits and a build-up in
external debt. Heavy foreign borrowing, often at short maturities, also exposed corporations
and banks to significant exchange rate and funding risks—risks that had been masked by
long-standing currency pegs. When the pegs fell apart, companies that owed money in
foreign currencies suddenly owed a lot more in local currency terms, forcing many into
insolvency.
Nambiar gave a very good example as for the case of Malaysia. As there was a concern in
the rapid growth in bank loans to the property sector. Roughly between 1991 and 1996 there
was a boom in property prices ranging annually from 10 to 17 per cent. Property developers
sought bank loans using stocks and property as collateral. This exposed the economy to two
forms of risk. First, there were signs of excess supply in the property market (Bank Negara
Malaysia, 1998:21-22). Second, with the extremely high prices in the stock and property
markets, banks were exposing themselves to risk in the event of a sudden fall in prices in
these markets. The rapid growth in bank loans to the property sector was symptomatic of the
preference structure of banks in respect to extending loans. Banks preferred to make loans
where high rates of return appeared to be assured, rather than to extend them for long-term
investments. Banks more readily extended loans for consumption credit, real estate
investments and share purchases rather than for manufacturing, agriculture or building and
construction, or for technology-based investment projects with long gestation periods (Chin
and Jomo, 2000). The banking system exposed itself to risk both in terms of the sectors it
favoured for loans and in terms of the collateral it accepted. In normal circumstances it would
be acceptable to take property and stocks as collateral. With the build-up of the property
bubble and the stock market boom, banks were opening the economy to financial fragility
(Nambiar 2003).

The third argues that the crisis occurred primarily as a result of structural and policy
distortions (Corsetti, Pesenti, and Roubini 1998; Dooley 1999). According to this view,
fundamental imbalances triggered the currency and financial crisis in 1997 even as after the
crisis started, market overreaction and herding caused the plunge in exchange rates, assets
prices, and economic activity to be more severe than warranted by the initial weak economic
and financial conditions.

It is about lack of enforcement of prudential rules and inadequate supervision of financial

systems, coupled with government-directed lending practices that led to a sharp
deterioration in the quality of banks' loan portfolios. Many Asian financial institutions were not
well-regulated or supervised, and they made risky loans based on the assumption that
property and asset values would always rise. When the crisis hit, these loans became non-
performing, leading to financial instability. Gregory and Ravenhill asserted that in few
instances did governments put in place an effective policy framework to cope with the new
inflows of foreign capital. In part, the problem was lack of experience. Governments had
neither the knowledge nor the bureaucratic capacity to cope with the regulatory challenges
posed by the enormous capital inflows. Even the more developed economies such as Japan
had relatively few trained bank inspectors, and throughout the region established ministries
resisted attempts to create new independent regulatory agencies. Although some
governments embraced the ideology of liberalisation, they ended up with an awkward half-
way house that often created a perverse incentive structure (Gregory and Ravenhill, 2000).
The licensing of new banks that followed partial liberalisation throughout the region created
its own set of problems. Many of these financial institutions were unknown to regulators who
were accustomed to operating in a framework of 'relational' banking. Moreover, new financial
institutions had a powerful incentive to increase market shares - and often did so by lending
to companies with dubious financial qualifications. Risky lending practices contributed to
another problem: the investment of increasing resources in largely unproductive activities.

Chowdury asserted however that structural and policy distortions are also reinforced by
external sector weaknesses, fragility in domestic financial markets due to inadequately
administered financial liberalization, loss of confidence and short term capital flows, which
some of these factors were country specific – but some were common to the entire region. It
is because in mid 1990s, several East Asia’s countries used Japan’s model of high savings,
close cooperation between the public and private sector, high level of education leading to
export oriented growth – had eventually transformed the countries from underdeveloped
states to industrials giants. The model however led to a large number of weaknesses for
example in corporate governance arrangements, poor regulatory and supervisory
arrangements in the financial sector, and propensity to high indebtedness (Chowdurry,
1999).

As in the case for some countries, financial liberalization had not been supported by
adequate macroeconomic policies and structural reforms. For example, capital account
opening in a number of countries allowed banks but not business enterprise to borrow
heavily in international markets which later les to more liberal movement of short term than
long term capital.

References
1. Steven Radeley and Jefferey David Sachs, 1998. The Onset of the East Asian
Financial Crises, National Bureau of Economic Research. 55.

2. Michael Carson and John Clark, Federal Reserve Bank of New York,
https://www.federalreservehistory.org/essays/asian-financial-crisis

3. Noble, Gregory W., and John Ravenhill. "Causes and consequences of the Asian
financial crisis." The Asian financial crisis and the architecture of global finance
(2000): 1-35.

4. Kok Fay Chin and K.S. Jomo, Financial Reform and Crisis in Malaysia, 2001
https://doi.org/10.4324/9781315195155

5. Shankaran Nambiar, 2003. MALAYSIA’S RESPONSE TO THE FINANCIAL CRISIS:

RECONSIDERING THE VIABILITY OF UNORTHODOX POLICY,
https://www.unescap.org/sites/default/files/apdj10-1-1-nambiar.pdf

6. JU ZHONG ZHUANG AND MALCOLM DOWLING, 2003. Lessons of the Asian

Financial Crisis: What Can an Early Warning System Model Tell Us?
https://www.worldscientific.com/doi/pdf/10.1142/S0116110503000046

7. James Chen, 2021. Plaza Accord: Definition, History, Purpose, and Its Replacement
https://www.investopedia.com/terms/p/plaza-accord.asp

8. Pablo Bustelo, 1998. The East Asian Financial Crisis: An analytical Survey. ICEI
Working Paper, https://asiayargentina.com/pdf/222-survey.PDF

9. Giancarlo Consetti, Paolo Pesenti, and Nouriel Roubini 1998. What caused the Asian
Currency and Financial Crisis: Part 1: Microeconomic Overview
https://pages.stern.nyu.edu/~nroubini/papers/AsianCrisis.pdf

10. Abdur Chowdurry, 1999.The Asian Currency Crisis, Origin Lessons and Future
Outlook https://epublications.marquette.edu/cgi/viewcontent.cgi?
article=1024&context=econ_fac