The past year and a half has certainly been an eventful one for international financial markets. Not since the Latin American debt crisis of the early 1980s has there been so much turmoil in world markets. Like dominoes tumbling, what started in Thailand in July 1997 soon spread to the other so-called Asian tigers—the fast-growing countries of East Asia. By mid-1998, the crisis was threatening to envelop countries in Latin America and Eastern Europe—most notably Brazil and Russia. Although conditions have stabilized somewhat in recent months, the crisis is far from over, and the effects on the United States and other highly developed countries have yet to fully play themselves out.

One of the more remarkable aspects of the crisis is the speed with which conditions deteriorated and spillovers occurred in other countries. Rapid advances in computing and other communications technology have enabled financial transactions to occur around the globe almost instantaneously. One of the painful lessons of the last 18 months is that capital can flow out of a country as quickly as it comes in—a process that can turn a molehill into a mountain. The crisis in Asia has raised many questions about the advisability of investing in emerging market economies and the role of domestic regulators and international organizations like the International Monetary Fund (IMF) in preventing and stemming the damage once it's under way. But the biggest questions remain: What happened, why did it happen and what can be done—if anything—to prevent similar crises in the future?

The Drop Heard Round the World

Until the summer of 1997, the world economy looked pretty stable. Although Japan was virtually in recession and its banking sector was badly damaged, the rest of the industrialized world was growing, and inflation was low. Mexico was recovering from its 1994-95 financial crisis, and there were no serious, obvious problems in major emerging market nations. This placid scenario changed dramatically, however, on July 2, 1997, when Thailand devalued its currency, the baht.1 Within the next several months, the currencies of neighboring Indonesia, Malaysia and the Philippines came under pressure, too, leading to depreciations against the dollar ranging from 25 to 33 percent. More modest depreciations then occurred in other parts of Asia, including Korea, Taiwan and Singapore.

In the fall and winter of '97, pressures on Asian currencies intensified. By January 1998, the currencies hit rock bottom. The Indonesian rupiah had dropped 81 percent against the dollar since July 1, 1997, the Thai baht, 56 percent, the Malaysian ringgit, 46 percent, and the Philippine peso, 41 percent. Meanwhile, between Oct. 1, 1997, and late December of that year, the Korean won depreciated 55 percent, and the New Taiwan dollar fell 19 percent. Exchange rates in other emerging market countries also came under pressure in the latter half of 1997, but central banks in these nations were generally able to defend their currencies.

The exchange rate crisis in east Asia prompted a pullback in private capital flows to the region (see below), which prompted further pressure on the region's exchange rates and more capital flight. International investors—especially banks and portfolio (stock and bond) investors—who had previously been pouring money into the region became nervous about the ability of Asian firms to pay it back. Much of this capital had been channeled through the affected countries' domestic banking systems, which had a number of structural problems. Because so many financial institutions and corporations in the region had borrowed in dollars and were consequently not protected against foreign exchange risk, the severe currency depreciations seriously weakened their balance sheets and increased credit risk.

Equity markets in both the affected countries and other emerging market nations—like those in Latin America—became very volatile. Spreads on emerging market debt, which had been very narrow in the year or so leading up to the crisis, jumped substantially, especially after problems emerged in Hong Kong in October 1997. International credit agencies began to downgrade emerging market sovereign (government) debt, dramatically increasing the cost of borrowing. Korea, which had been one of the great success stories in the developing world, suffered the ignominious distinction of having its debt fall to below investment grade, or "junk bond" status—one of the largest downgradings in recent history.2

Austerity programs instituted by the IMF as a condition of financial assistance seemingly exacerbated the crisis. Monetary and fiscal policies were tightened to try to get exchange rate levels under control, causing domestic interest rates to further rise and growth to slow. Many domestic banks became insolvent in market value terms as nonperforming loan levels climbed; in some cases, bank runs even occurred. Domestic credit crunches emerged since banks were too undercapitalized to lend. In countries where sovereign debt was significantly downgraded, banks could no longer issue internationally recognized letters of credit for domestic exporters and importers. Since these countries were highly dependent on trade, and were counting on export revenues to help dig themselves out, this restraint only made matters worse.

In some countries, especially Indonesia, severe political unrest accompanied and exacerbated the economic turmoil. Further compounding Asia's situation was Japan's continued weakness. By the end of 1997, Japan had slipped into recession and was not able to help its neighbors with additional investment or increased trade. Although conditions in the region stabilized somewhat by late 1998, it will be several years before these formerly fast growing economies get back on track.

What Went Wrong?

The crisis in Asia caught nearly everyone by surprise. After all, this was a region that had accounted for more than half of the world's economic growth in the 1990s. Inflation was low, and there were no obvious fiscal or monetary imbalances. Although many of the countries in the region were running high current account deficits—as they had been for a number of years—the deficits were not generally viewed as a problem since international investors seemed more than willing to supply the capital to finance them.

If investors and policy-makers had been looking a little more closely, however, they would have seen a number of similarities between the period preceding the Asian crisis and the periods leading up to the two previous international financial crises—the 1980s Latin American debt crisis and the 1994-95 Mexican financial crisis. First, capital inflows to the affected crisis areas were extremely heavy prior to the downturns as international investors enjoyed easier access to domestic financial markets. In the previous two crises, spreads on emerging market debt declined substantially as investors downgraded the risk difference between developed countries' and emerging market countries' debt. Second, the affected regions enjoyed strong ratings from international credit agencies and widespread investor participation in their markets. In Asia, as in the other two crisis regions, both of these factors could be viewed as very positive developments—a veritable stamp of approval from the international financial community.

But, as in the prior two crises, there were warning signs that all of the confidence in Asia may have been misplaced. Most domestic borrowers, for example, were unhedged against exchange rate risk. This meant that a large change in a borrowing country's exchange rate could have dramatically increased the cost of paying back the dollars it borrowed from foreign investors.

Even more ominous were structural problems in the region's financial sectors—especially banking—which left them ill-equipped to manage the sheer volume of investment flows. A laundry list of some of these problems includes: extensive government involvement in private-sector investment allocation; underdeveloped and underregulated equity markets; "crony capitalism" and corruption in banks; overly close linkages between banks and major industries (called "connected lending"); weak corporate governance; poor supervision and regulation of financial institutions; and a general lack of transparency in the economy's financial sectors. Underlying all of these weaknesses, according to many economists, was pervasive moral hazard—a "heads I win, tails someone else loses" philosophy. Banks, investors and firms assumed that the region's governments and international organizations would bail them out in the event of financial catastrophe.

A Tale of Two Triggers

Since the crisis began, economists have searched for answers as to what triggered the crisis in Asia and its spread to other emerging markets around the world. Although a number of explanations have been offered, the vast majority of views fall into one of two camps: the "fundamentalist" view, espoused by Massachusetts Institute of Technology economist Paul Krugman, among others; and the "panic" view, most closely associated with Harvard economist Jeffrey Sachs and World Bank chief economist Joseph Stiglitz. The fundamentalist view focuses on how the borrowing countries' policies and practices fed the crisis, whereas the panic view focuses on the role lenders played.

The fundamentalist view holds that flawed financial systems were at the root of the crisis and its spread.3 Although there were no obvious macroeconomic forewarning signals, there were changes occurring in these economies that made them vulnerable to a financial crisis. The seeds for the financial crisis were actually sown several years before currency pressures began. Because most currencies in the region were in some way pegged, or tied, to the U.S. dollar, the appreciation of the dollar versus the yen and other major currencies over the past several years meant that Asian countries were losing competitiveness in export markets. As a result, export growth—the engine driving these economies—began to slow. Meanwhile, an increasing portion of foreign capital inflows to the region consisted of liquid portfolio investment, rather than long-term foreign direct investment (FDI).

The bulk of these liquid capital flows were channeled into domestic investments by local bank and nonbank financial institutions. Frequently, the same assets—land, real estate and financial assets—were used for collateral and investment, driving the value of existing collateral up, which, in turn, spurred more lending and increased asset prices. Risk was further heightened when local banks—in response to low interest rates overseas and "stable" exchange rates at home—began borrowing foreign exchange abroad. These local banks then converted the foreign exchange to domestic currency and lent the proceeds domestically, assuming all the exchange rate risk. These risky practices went unnoticed and/or unchallenged in the weakly supervised and crony-controlled banking systems in which they occurred.

According to the fundamentalist view, such a bubble was bound to burst in the face of a shock. Some analysts have argued that the increase in U.S. interest rates in early 1997 provided the pop, while others say it was the decline in the world prices of exports—computer chips and commodities like rice, wood and rubber—from these countries. Regardless of the exact cause, asset prices fell, causing nonperforming loans to rise and the value of collateral to fall; domestic lending then declined and asset prices fell yet again.

Foreign and domestic investors subsequently got spooked, and capital started to flow out of the region. This put pressure on the exchange rate pegs in the region. Because of the fragile state of the region's domestic financial systems, the monetary authorities risked further financial turmoil if they attempted to raise interest rates to defend the pegs. So the pegs were ultimately abandoned. Because so much of the foreign currency debt was unhedged, the currency depreciations led to widespread bankruptcies and slowing economic growth.

Subscribers to the panic, or "disorderly workout," theory, on the other hand, maintain that the economic fundamentals in Asia were essentially sound. Rather, a swift change in expectations was the impetus for the massive capital outflows that triggered and fed the crisis. Economists Steven Radelet and Jeffrey Sachs (1998) essentially argue that a molehill (problems in Thailand) was turned into a mountain (a regional financial crisis) because of international investors' irrational behavior and the overly harsh fiscal and monetary medicine prescribed by the IMF as the crisis broke.

They point to several factors that support the premise that the crisis was panic-induced. First, the crisis was largely unanticipated. There were no warning signals, such as an increase in interest rates on the region's debt or downgradings by debt rating agencies. Second, prior to the crisis, there was substantial lending to private firms and banks that did not have any sort of government guarantee or insurance (a large proportion of which have gone into or are now facing bankruptcy). This fact contradicts the idea that moral hazard was so pervasive that investors were knowingly making bad deals, assuming that they would be bailed out. It is consistent, however, with the notion that international investors panicked in unison and withdrew money from all investments—good or bad.

Third, once the crisis was under way, the affected countries experienced widespread credit crunches—even viable domestic exporters that had confirmed sales could not get credit—again suggesting irrationality on the part of lenders. Fourth, the trigger for the crisis was not the deflation of asset values, as the fundamentalists argue, but, rather, the sudden withdrawal of funds from the region. Radelet and Sachs argue that some of the conditions the IMF imposed on these countries for financial assistance "added to, rather than ameliorated, the panic." 4

Never Again?

Regardless of the cause of the crisis and its consequent spillover to other countries, all analysts agree that the fallout in Asia and other emerging market nations has been severe. Although initially only financial in nature, the crisis has led to significant real economic losses in these formerly fast-growing economies. It is clear—whether one believes the fundamentalist theory or the panic theory—that the region's financial sectors did not "evolve in parallel with economic performance." 5 Moreover, international investors overinvested in the region because of a lack of opportunities (low interest rates) in the United States and Japan. This global chase for short-term profits caused herding, myopic behavior on the part of investors. At the same time, investors were misled—deliberately, in a few cases—about the ability of Asian economies and financial markets to absorb and profitably employ the massive inflows of foreign capital. In short, there is plenty of "blame"to go around.

While most analysts agree on the steps—especially reform of the banking sector—these countries must take to get back on solid economic footing, they acknowledge that Asian governments face a number of enormous challenges to meet those goals. First, many of the changes that the IMF, the G-7 countries and others offering help have insisted upon have proved to be extremely difficult to implement politically in several countries. Leaders like former Indonesian president Suharto—who was eventually forced to resign—and Malaysian president Mahathir Mohamad were extremely reluctant to enact the needed reforms and clashed with both their governments and political opponents, creating credibility problems abroad and political unrest at home.

Second, one of the short-term prescriptions for restoring economic health—a large boost in exports—is running into complications. Japan's continued economic weakness means that one of the region's major export markets is essentially out of commission. And in other countries, like the United States, protectionist sentiments have been aroused by the increase in cheaper imports from the region, making it difficult for Asian exporters to make further inroads in this market. U.S. steel producers, in particular, have been very vocal about the perceived threat to the U.S. steel industry from the post-crisis drop in world steel prices.6

At this point, most economists expect the Asian countries to return to good health in the next several years. The outlook for non-Asian countries affected by the contagion—notably Brazil and Russia—is more uncertain, however. In mid-November 1998, Brazil agreed to a $42 billion IMF-led program to stabilize its economy and soothe the still jittery international investment community.7 Russia is a tougher case. The first IMF program there collapsed soon after its enactment, as the Russian government first squandered the initial funds the IMF provided, then devalued the ruble and defaulted on its sovereign debt, and failed to undertake any of the IMF's prescriptions for more aid.8

As with previous crises, the next step will be assessing the lessons learned and devising prescriptions for mitigating similar future crises, wherever they might occur. Clearly, greater transparency in financial transactions, more stringent regulatory oversight and consistent application of accounting standards would go a long way toward preventing a collapse the size of Asia's. But no country in the world will ever be immune from a financial calamity (remember the U.S. savings and loan debacle of the 1980s?). Moreover, the "regulatory straitjacket" that would be necessary to prevent any type of crisis from occurring would also cut nations off from the many benefits that come with participating in the international financial community. To proclaim "never again" is foolhardy; to strive for less fallout and contagion when these crises occur is a goal worth pursuing.

Thomas A. Pollmann provided research assistance.

Endnotes

1. For detailed overviews of the events leading up to and including the crisis, see International Monetary Fund (1998) and Corsetti, Pesenti and Roubini (1998). An excellent web site containing hundreds of articles on the Asian crisis is maintained by Nouriel Roubini of New York University. The web address is: www.stern.nyu.edu/~nroubini/asia/AsiaHomepage.html#intro1 [back to text]
2. Indonesia's and Thailand's sovereign debt was similarly downgraded. [back to text]
3. See Krugman (1998), Noland et al. (1998) and Corsetti, Pesenti and Roubini (1998) for a detailed explanation of the fundamentalist view. [back to text]
4. Radelet and Sachs (1998), p. 44. [back to text]
5. Noland et al. (1998), p. 3. [back to text]
6. See Wayne (1998). [back to text]
7. See Blustein (1998). [back to text]
8. See Sanger (1998). [back to text]
9. Part of the outflow of reserves was due to the inability of Korean banks to roll over their international bank loans, which forced the Bank of Korea to stop in and assist the banks, providing dollars to pay off the bank loans. The central bank was also providing dollars to domestic firms that could no longer get them from domestic banks. [back to text]

References

Blustein, Paul. "U.S., IMF Announce Plan to Avert Brazilian Crisis," Washington Post (November 14, 1998).

Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini. "What Caused the Asian Currency and Financial Crisis?" Mimeo, New York University (September 1998).

International Monetary Fund. International Capital Markets: Developments, Prospects, and Key Policy Issues, Washington, D.C. (September 1998).

Krugman, Paul. "Asia: What Went Wrong," Fortune (March 2, 1998), p. 32.

Noland, Marcus et al. "Global Economic Effects of the Asian Currency Devaluations," Policy Analyses in International Economics, Institute for International Economics (July 1998).

Radelet, Steven, and Jeffrey Sachs. "The Onset of the East Asian Financial Crisis," NBER Working Paper No. 6680 (August 1998).

Sanger, David E. "As Economies Fail, the IMF is Rife with Recriminations," New York Times (October 2, 1998).

Wayne, Leslie. "American Steel at the Barricades," New York Times (December 10, 1998).