The East Asian Financial Crisis: Diagnosis, Remedies, Prospects

Steven Radelet, Jeffrey D. Sachs, Richard N. Cooper, and Barry P. Bosworth

Summary by: Daniel Coffman and Andrew Henkel

Emerging Market Crisis

• Crises often occur when economies that have been on the receiving end of large capital inflows stop receiving capital and instead face creditors demanding repayment

• Sudden reversal of cash-flows often leads to default on loans, rescheduling of payments, or bailouts

Self-Fulfilling Crises

• Individual creditors may act rationally, but market outcomes lead to sudden reversals of cash-flows.

• Difference between illiquidity and insolvency– Illiquidity: The borrower has the net worth to

repay all loans, but lacks quick access to ready cash

– Insolvency: The borrower does not have the net worth to repay loans

• Even though the borrower may be solvent, they may not be able to get new loans to meet current debt obligations.

• Leads to liquidity crisis• Root cause in international markets lies in the

bank’s tendency towards herd behavior– Banks react to the activities of other banks instead

of individual debtor’s attributes

Domestic Markets

• Domestic capital markets are less prone to self-fulfilling crises

• Advanced economies have mechanisms to limit the onset of panics

• In the United States, we have the Federal Reserve, which acts as the lender of last resort in the event of a bank run

Was the East Asian Miracle A Mirage?

• The rapid growth seen in many East Asian countries was real

• The rapid expansion of the financial industries in many countries was not met with more complete regulation and oversight

Response to the Crisis

• In this article, the response is divided into two phases– Phase 1: August 1997 to December 24, 1997– Phase 2: December 24, 1997 to April 1998

(publishing date)

Phase One

• Emergency lending agreements from the IMF– Thailand- $17B– Indonesia- $35B– S. Korea- $57B

Loan Terms

• Loans to be made available in order to repay debts and stabilize exchange rates

• Economic planning to include budget balance or surplus, high nominal interest rates, and restrictive domestic credit targeted at exchange rate stability

• Financial sector restructuring to include closure or suspension of several financial institutions and increased oversight of financial institutions

Phase Two

• Dec. 24, 1997- U.S. Government decides to press foreign commercial banks to roll over Korean short-term debt credits

• Jan 28, 1998- $24B of Korean short-term debt is converted to claims with maturities between one and three years

• Korean Won stopped depreciating, and decline of stock markets slowed in all three crisis countries

• In Thailand, the government released a formal guarantee of all outstanding private and public liabilities to foreign creditors

• In Indonesia, previous loan agreements with the IMF were intensified, followed by announcements of de-facto suspension of payments on short-term debt and the guarantee of all commercial debt.

• Eventually these strategies worked and currency depreciation slowed

Sources

• Radelet, Sachs, Cooper and Bosworth (1998), “The East Asian Financial Crisis: Diagnosis, Remedies, Prospects,” Brookings Papers on Economic Activity, 1-90.

What Caused the Asian Currency and Financial Crisis?

Giancarlo Corsetti, Paolo Pesenti, Nouriel RoubiniHa-Joon Chang

Two Views on the Causes

• One view: Sudden shifts in market expectations—investor panic– Explored in detail in the Radelet & Sachs paper

• Another view: Structural and policy distortions in many Asian countries

Moral Hazard• Moral hazard at three different levels• Corporate:

– Tradition of public guarantees to private projects led to ignoring costs and risks in project planning

– Governments frequently coerced domestic financial institutions to make loans

– High capital inflows despite sustained poor returns• Financial:

– Excessive borrowing from abroad and domestic lending by national banks– Many structural distortions ranging from lax supervision and insufficient

expertise to outright corruption– Non-performing loans came to constitute upwards of 10% of total lending

on some countries

Moral Hazard

• International:– Substantial lending by international banks with little concern

for risk assessment– Expectation of bailouts—“too big to fail”– Sustained economic stagnation in Japan affected trade

balances by causing a slowdown in export growth– Appreciation of US dollar hurt cost-competitiveness– Competitive pressures increased due to China’s rising export

economy– Reserves of foreign currency were insufficient in several

countries to cover external obligations in the event of a liquidity crisis

Macroeconomic Fundamentals

• The countries hit hardest by the crisis had all been running substantial current account deficits throughout the 1990s—as high as 10% of GDP– Other economies in the region such as Singapore, Hong

Kong or Taiwan were running current account surpluses• These countries also all had large foreign debt to

GDP ratios• High rates of growth in the area that proved to be

unsustainable were incorrectly projected into the future, promoting large capital inflows

Macroeconomic Fundamentals

• Investment efficiency was already falling in Asia even before the crisis– Most of the largest Korean chaebols had a return

lower than their cost of capital• Political instability, such as that in Thailand

and Indonesia, created additional market uncertainty

Distress in 1997

• Thailand: Even before the crisis, a large number of Thai financial institutions were effectively bankrupt– Thailand ultimately had some 56 financial institutions go

bankrupt after the government abandoned plans to bail out its finance sector in favor of trying to save the baht

• Korea: The crisis was preceded by several bankruptcies among the chaebols in early 1997– This led to a shocking drop in industrial growth and

greatly affected the financial sector, which had borrowed abroad and loaned to many of the bankrupt companies

Distress in 1997

• Malaysia: The central bank’s delayed response to a real estate bubble sparked a stock market crash in early 1997– The Malaysian stock market continued to decline

throughout the crisis• Japan: In 1997, an apparent recovery in the

leading regional economy was wiped out by yet another recession

Currency Crises• Speculation attacks were launched against many currencies in the

region, which had been pegged to the dollar– First was the Thai baht, which was allowed to float in July– Malaysia, Indonesia and the Philippines were all subsequently targeted

• Over the course of 1997, the values of these four currencies dropped precipitously by between 25% and 45% of their prior value

• Speculation also was brought against Singapore, Taiwan, Hong Kong and Korea– The first three countries only suffered moderate depreciation, but the

won ultimately dropped in value by almost half—25% in November 1997 alone

Effectiveness of the IMF Response

• The IMF-prescribed high interest rates may have contributed to the 1998 recessions by being sustained too long

• The IMF’s handling of insolvent banks may have resulted in destabilization of otherwise healthy banks elsewhere in the region

• IMF disbursements may have increased moral hazard issues on a global scale, though evidence suggests that not issuing this type of disbursement in a crisis likely has worse results than those created by moral hazard

Global Effects

• In 1998, the East Asian crisis spread to international markets

• Hong Kong, Singapore, the Philippines and Taiwan all experienced recessions

• Japan’s recession worsened• Commodities prices fell sharply, affecting Latin America• A severe economic crisis hit Russia following the collapse

of its currency and threatened to affect US capital markets• Despite fears of a global recession, investor confidence

improved near the end of the year, likely due to concerted US and international actions

Sources

• Chang, H-J. (2000), “The Hazard of Moral Hazard: Untangling the Asian Crisis,” World Development 28 no. 4, 775-788.

• Corsetti, Pesanti and Roubini (1999), “What caused the Asian currency and financial crisis?” Japan and the World Economy 11, 305-373.