Chapter 2 The Asian Financial Crisis
- International Monetary Fund
- Published Date:
- January 2001
The Asian financial crisis—the topic has dominated headlines throughout the world. Since July 1997, there have been more than 16,000 articles, journals, and reviews published nationally and internationally on this subject.
An economist always hesitates to make an unqualified prediction, but I think it’s safe to say that there will be many thousand more before the subject is exhausted. Throughout this crisis, medical references have been commonplace. Asian economies are “ill” or in “poor health.”
The name “Asian flu” has been transformed in the national vocabulary to an economic term. We worry about how contagious it is, and whether it’s reached epidemic proportions. Some have called for “economic penicillin” to solve this crisis. Others have said that any solution should be similar to a doctor’s approach to a patient—”First, do no harm.” That’s probably not bad advice for economists and policymakers, as well as doctors. And I think it’s useful advice in looking at the Asian crisis. But I hope we can do more than just avoid harm.
I hope we can learn from this event and begin to develop policies to help prevent future crises. In that sense, the Asian crisis represents an opportunity for positive change. And I believe this conference is an opportunity to significantly increase our understanding of what constitutes effective policy.
Our understanding of the Asian crisis has already changed dramatically. When the crisis broke out with the collapse of the Thai baht in July 1997, many believed the damage would be confined to a handful of small Asian economies. Some fourteen months later, it’s clear how myopic that thinking was. The crisis has spread to other East Asian countries and to Russia. Just a few weeks ago, Latin America began to encounter serious troubles.
Some claim to have recognized the potential for crisis long before it began. But most experts were taken by surprise by the speed and the timing of the crisis. And the future is highly uncertain. But as Alan Greenspan stated in September, it seems unlikely that the United States can remain an oasis of prosperity.
The international system of capital markets has been radically transformed in recent decades. Today, we have an interdependent, interlinked global financial system with the ability to react to events at incredible speed. This global system has made a substantial contribution to living standards worldwide. But it also responds with brutal speed and efficiency in moving money away from potential risks.
More than ever, financial markets seem to drive developments in the real sector, rather than passively responding to the ebb and flow of real productive activity. In fact, some have characteried the Asian crisis as a virtual decoupling of the financial and real asectors of the economy. The years preceding the crisis were a period of exceptional growth in East Asia. No real macroeconomic distortions were observed.
The economies of the five crisis countries had low inflation, their budgets were generally in surplus, and government foreign debt was declining as a percentage of GDP. During the 1990s, these governments engaged in responsible monetary expansion. The unemployment rates were low. In short, these governments had a good record of managing the real side of the economy.
Instead, the weaknesses seem to have been on the financial side. In the months leading up to the crisis, economic activity was financed increasingly with short-term capital inflows. Short-term capital is “hot money:” It can flow rapidly into countries where expected returns are high; it can flow out just as rapidly.
What precipitated the massive reversal of capital flows we saw in the Asian crisis? Did investors rationally forecast a fall off in economic productivity? Or did investors suffer an exogenous loss of confidence, not triggered by any real economic shocks? Worse yet, did the loss of confidence so damage the business climate that investors’ pessimism became self-fulfilling?
This scenario would be the economic equivalent of the tail wagging the dog: real economic activity damaged by a malfunctioning financial sector, rather than the reverse. It remains to be seen whether this characterization of the Asian crisis proves to be the most useful way to think about these events. We have the opportunity to consider the Asian crisis from many different perspectives, in order to better understand its causes and consequences.
I think it’s fair to say that there are as many theories about what caused the Asian crisis as there are people at this conference. However, two issues that are likely to be central to understanding the Asian crisis are the distortion of market forces and the resulting moral hazard. If you peel back the many layers of the Asian crisis, you’ll find these issues at the core.
Focusing on market forces and moral hazard is important because they are key to preventing a bank crisis. The prompt resolution of a banking crisis is important, of course. But regulators tend to focus much of their time and attention preparing to pick up the pieces after the crisis. We can spend less time on resolving crises by spending more time on preventing them.
Ironically, many point to the turmoil in Southeast Asia as eveidence of a breakdown of capitalism—a failure of market forces. An alternative view is that the crisis resulted from government interference in the normal operation of financial markets. To what extent were dubious investments cheerfully funded by banks as long as the borrower had the right government connection? To what degree was patronage more important than profits? Clearly, these sorts of distortions could subvert the fundamental function of banks as efficient allocaters of credit, and they could undermine the market discipline needed to ensure that financial institutions were properly allocating risk. The weakening of market discipline left these countries susceptible to moral hazard.
Korea, Indonesia, Thailand, and Malaysia among others have strong interlocking relationships between the public and private sectors. Did these relationships carry with them an implicit guarantee of financial institutions? Did lenders assume that their investments were protected by national governments? Did investors in financial institutions exercise insufficient prudence as a result? And were even the more prudent investors unable to make informed choices because of the lack of transparency in Southeast Asian banks? Weakened market discipline is a common thread connecting those countries suffering from economic crisis. They may differ in the way market forces were distorted, but the outcomes were essentially the same.
Now these nations must grapple with the question of how to restore the levels of economic performance that so impressed the world during the years prior to the crisis. Some nations seem to have grown impatient with global markets, and threaten to turn toward isolation. Malaysia imposed currency and stock market controls in an effort to insulate its economy. Russia appears to be reverting to a less market-driven economy.
And even Hong Kong, a bastion of free markets, bought an estimated $15 billion worth of stocks to bolster prices after sell-offs by speculators. Are Asian countries losing faith in free markets. Certainly there’s growing anger among some officials, business leaders, and citizens about the crisis. And free markets are an easy target.
But obviously no one can truly “opt-out” of the global financial community. That’s no longer a realistic possibility. A return to prosperity for those countries in crisis requires a commitment to market reform. The two are inseparable. I’m sure that market forces and moral hazard are two issues that will feature prominently in our discussion. There are, of course, a number of other important issues that we’ll cover during the next three days. Here are just a few of the key questions that we’ll be discussing:
What were the causes of the Asian financial crisis and why was its onset so sudden and unpredictable?
- How effective have international rescue operations been in dealing with the crisis?
- How should the international financial system balance the stability gained from a financial safety net against the potential risk of moral hazard?
- How has the opaqueness of Asian financial markets contributed to the crisis?
- Is the Asian crisis a failure of market-oriented capitalism or a failure of state-managed capitalism?
- How has openness to market forces affected the severity of the financial crisis in each country?
- And, perhaps most importantly, what actions can be taken to prevent future crises?
The answers to these questions, and many others we will be discussing will help share the future of public policy related to the international financial system. I am pleased that we have some of the leading experts from the academic, regulatory, and financial services industries to discuss these issues.