The South East Asian Currency Crisis Revisited

Let us revisit South East Asian Currency Crisis and understand in retrospect the causes leading to a huge economic meltdown of countries which were once considered as the “poster boys” of the International Monetary Fund for their export promotion strategies.

The South East Asian currency crisis broke out in Thailand in 1997. The financial crisis affected many Asian countries, including Thailand, Malaysia, Indonesia, Singapore South Korea and the Philippines. After posting some of the most impressive growth rates in the world at the time, the so-called “tiger economies” saw their stock markets and currencies lose about 70% of their value. This crisis has been represented as an illustration of the perils of a moral hazard. These states, in the hope of attracting credit and in turn investment, offered an implicit bailout policy. This means that in case of a project failure, the state would bail out the funds. It is only natural that borrowers and lenders tend to be less careful while evaluating the true profitability of investment opportunities if they believe that they will get bailed out in the event that the project goes badly. Both lending institutions and investors were completely insulated and hence, high risks were taken and a large amount of speculative investment went into the non-traded sector.

A short time earlier, some practices were marked as strengths of the Asian economies. These included domination of business deals by personal connections ( guan xi in China), large family-run conglomerates (chaebol in Korea), comprehensive clusters of allied firms (keiretsu in Japan) and insider links to the government (“KKN” protests against President Suharto in Indonesia). These strengths suddenly became major weaknesses of these economies. The term “crony capitalism” gained a lot of popularity in 1997. Firms funded investments by borrowing from bankers with whom they had close personal or political ties. These took the form of connected lending and directed lending cresting a base for the relationship-based system of lending. In such a scenario, corporations often pursue “empire building,” seeking to maximize their size, without regard to profitability or shareholder value.

Another factor that led to this impending crisis was a lax monetary supervision. As these Asian Tigers started trade liberalisation in the 1980s, they opened their capital accounts. A lot of capital, in the form of Foreign Portfolio Investment (FPI) and External Commercial Borrowing (ECB), flew in. Now, FPI’s volatile nature of capital flow (because it comes into the country in huge amounts but can also flow out with equal ease) led to the problem of currency mismatch with the second component, ECB. This problem occurred because the private sector borrowed heavily from the foreign capital market. This loan was denominated in foreign currency but was to be repaid in domestic currency because the revenue earned is in domestic currency. The rate of growth of credit exceeded the rate of growth of output by a wide margin. This caused the overheating of the economy. As a result, the economy became extremely sensitive to fluctuations in the credit market. For example, if the interest commitment on an ECB is USD 1 and if the home currency depreciates, the debt servicing charge as expressed in the home currency shoots up. This leads to a fall in the profit and hence, investment falls. As is clear by this example, the whole economy was thriving on bubbles.

A distinctive factor of this crisis was that the turmoil spread beyond the country of origin. This tendency to spill over is termed as contagion. Even a country with strong macroeconomic fundamentals may find itself attacked when a neighbour suffers a speculative attack. When the currency crisis hit Thailand, substantial amount of foreign credit was taken out of the country. As a result of this, panic spread and domestic credit was also withdrawn. Due to the contagion effect, this spread like wildfire. This is when the widespread recession surfaced. This spillover is not entirely irrational on the part of the investors. If two countries are major trading partners or if they compete in third country export markets, the second country may find itself in a helpless position when the first devalues its exchange rate. The second country stands to lose its export competitiveness if it does not devalue. Because of the presence of a heavy geographic pattern in trade, it is natural to suspect such competitiveness effects when the contagion runs along regional lines. This is exactly what happened. When Thailand devalued, Taiwan felt obliged to follow suit in order to remain competitive. The crisis soon spread to Hong Kong, Indonesia and Malaysia too.

Multiple lessons can be learnt from the 1997 crisis. Most important of them all is that any economy shouldn’t panic immediately if it’s neighbour is in a crisis.  If a group of countries panic at the same time, it will lead to unnecessary capital flight from the region to elsewhere with the region’s currencies taking a severe beating. No wonder the stock markets in US showed a significant surge when South East Asian ‘Tigers’ were still reeling under a shock.

– Contributed by Vinny

Picture: Burning and looting by people in Indonesia during the 1997 crisis (Picture Credits –

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