Chapter 11 Causes and Implications of the Asian Crisis
- International Monetary Fund
- Published Date:
- January 2001
Earlier speakers have already identified a number of internal factors that appear to have played an important role in the buildup to the Asian crisis. I will, therefore, first discuss the role of the external environment and then briefly address the implications of the crisis for Asia’s near-term growth prospects.
Few economies have benefited as much from globalization as the countries of southeast and east Asia. It is, therefore, a tragic twist of fate that these countries should become the victims of a financial crash brought on by a sudden shift in global financial market sentiment. Work has been underway during the past year at the IMF and by many others to try to identify the main causes of the crisis, but arriving at a full understanding of the forces that produced the Asian crash of 1997–98 will, of course, require extensive further diagnosis. At this stage, my preliminary conclusion is that the crisis resulted from the interaction between, first, external events largely beyond the control of the countries concerned, and second, a number of serious shortcomings of the “managed development models” characteristic of many Asian economies.1 These models or approaches to economic policies have been widely credited for the region’s earlier successes and the notion of an “Asian Miracle,” but the crisis has cast doubt on at least some of their features.
The role of the external environment can best be appreciated from a flow of funds perspective. Typically, cross-border flows of funds are quite sensitive to cyclical divergences among the major countries and regions. This has also been the case in the 1990s. At the beginning of the decade, virtually all of the major countries experienced successive economic downturns. These downturns occurred for quite different reasons, which had an important bearing on the shape of the subsequent recovery.
In the United States, the economy recovered very quickly and has subsequently enjoyed an exceptionally long and strong expansion. In the United Kingdom, where the recession was much deeper than in the United States, the subsequent recovery was also very strong. In both the U.S. and the U.K., the output gaps that had emerged earlier in the decade had been eliminated by 1997.
In sharp contrast, the pickups after the recessions in Japan and the major continental European countries were unusually sluggish: In Germany and France, for example, growth has only been above potential twice (in 1994 and 1998) during the past seven years, and in Japan only once (in 1996) since 1992, and the Japanese economy has now fallen back into an even deeper recession than in the early 1990s.
These large cyclical divergences between the U.S. and the U.K. on the one hand and continental Europe and Japan on the other, which gave rise to procyclical movements in exchange rates, also resulted in a sharp widening of current account imbalances. Japan’s surplus surged to over $130 billion in 1993-94 and the future euro area’s surplus exceeded $110 billion by 1997. The counterpart to these large surpluses were large, mainly private, capital flows from Japan and Europe not only into the United States but also into many emerging market countries, especially those in Asia. Of course, not all capital flows to emerging market countries originated in Japan and Europe; U.S. investors also contributed. But the large net movements of capital into emerging market countries from the early 1990s until 1997 clearly could not have occurred in the absence of these large surpluses. In my view, this was an absolutely critical element in the buildup to the Asian crisis, which is often being ignored.
While these capital flows were not exceptionally large from the perspective of the originating countries, they were very large from the perspective of the recipients. And large capital inflows are rarely sustainable. As it has happened so often in past episodes of large-scale movements of capital into developing countries, the tide will eventually turn. It can turn as cyclical conditions normalize in the originating countries, raising expected returns on investments at home. Or the capital flows can decline, or even be reversed, if investors eventually decide that the returns abroad (in emerging markets) are no longer worth the risk, for example, if perceptions of countries’ fundamentals change.
Which explanation fits the Asian episode? By 1996 there had been some signs that the global upturn was gaining momentum. In the United States, economic slack had been substantially absorbed and concerns about overheating became more prominent. In Japan, there was a sudden (albeit short-lived) burst of dynamism, and in continental Europe, activity seemed to be picking up. Indeed, expectations in financial markets seemed to suggest that interest rates in the industrial countries were likely soon to begin to head upwards.
In the event, however, although international cyclical conditions had begun to change, revised perceptions about the fundamentals of the emerging Asian economies were unquestionably much more important in triggering the virulent crisis. Other speakers have discussed some of the most critical factors that led to the changed assessment of fundamentals and the contagion that ensued; I need not repeat their conclusions, which I broadly share, including the role the capital inflows played in exacerbating problems of overheating and imprudent borrowing and lending.
At this stage, many aspects of the crisis remain unresolved, including the reasons for the unexpectedly severe compression of output, and the likely shape of recovery.
Regarding the reasons for the depth of the downturn in activity, the fact that it is a regional crisis, and that so many economies are affected, clearly plays an important role. All of these countries had benefited greatly from the rapid expansion of intra-Asian trade during the past decade or so. And now with much of the region in recession, the strong intra-regional trade links are working in reverse. That Japan, Hong Kong SAR, and Singapore are also in recession both reflects and contributes to the compression of output in the economies at the center of the crisis.
A more controversial issue is whether the depth of the downturn may also reflect the possibility that the fundamentals of the crisis afflicted countries may have been in worse shape than has been generally recognized. There is, I believe, considerable evidence in support of this hypothesis: The very high rates of capital accumulation characteristic of these countries, appear to have been associated with declining efficiency of new investments and falling rates of return; the volume of problem loans in the banking systems had been rising already before the crisis (although lack of transparency meant that these problems were not visible); and there were mounting signs of overcapacity in industry and in the construction sector, and property market bubbles had begun to burst well before the crisis broke.
When one adds up the evidence, it becomes clear that these economies were facing the likelihood of at least a business cycle downturn, and perhaps also a slowdown in trend growth, even in the absence of the financial crisis. The problem was that these strains and imbalances had been ignored for too long by domestic and foreign investors and banks, and by decision-makers across the region. The failure to read the writing on the wall was probably due to the familiar reluctance to quarrel with success: There was a widespread belief at home and abroad that the Asian Miracle would continue and that these countries were somehow immune to business cycle fluctuations.
Because of the exuberant expectations that existed both within and outside the region, the shock to investor sentiment when the crisis hit was particularly severe. And when investors opened their eyes to the more problematic features of Asia’s impressive growth record, they suddenly became aware of the potential (and need) for a cyclical correction and also began to question of the sustainability of underlying growth trends. The Asian Miracle suddenly lost its shine.
Looking ahead, what can the region expect and how supportive will be the external environment these countries will be facing during the period ahead?
We have seen very large contractions in economic activity: by almost ten percent on average for the worst afflicted countries. With output probably still falling in the final quarter of 1999, it may appear that the downturn will never end. What are the forces that will gradually emerge to support a turnaround and ignite recovery? There are in fact three such forces that are likely to generate at least a moderate pickup in growth during 1999:
- First, the turnaround in financial market confidence, which is being aided by the implementation of reforms and restructuring measures and large-scale international financial assistance.
- Two, both monetary and fiscal policies have become very supportive in all cases, which has been made possible by the return of confidence and by the low levels of public debt in most cases.
- Three, competitive positions remain very strong despite the rebound in exchange rates, which should help stimulate exports.
At the same time, questions remain about the health of financial systems and about corporate indebtedness. Frameworks are being put in place to facilitate the needed consolidation, restructuring, and recapitalization. While the decline in interest rates and rebound in exchange rates are substantially facilitating the task of restructuring, the full resolution of these problems will necessarily require some time.
Uncertainties also remain about the external environment. An early pick up in Japan is particularly critical to support recovery elsewhere in Asia. And the containment of financial pressures and contagion in other regions will also have a bearing on Asia. In the wake of the Russian crisis, major uncertainties remain about investors’ and banks’ appetite for emerging market risk and thus about the levels and terms of capital flows to emerging markets during the period ahead. There is some reason for optimism that strong preemptive actions by Brazil to forestall a financial crisis will allow the international community to help erect a firewall against further contagion. But it is too soon to conclude that the crisis is over.
Some of the work by the IMF on the causes of the crisis has been published in recent issues of the World Economic Outlook (December 1997, May 1998, and October 1998). See also background study for the “World Economic Outlook by Nicholas Crafts,” East Asian Growth before and after the Crisis, IMF, working paper, No. 98/137, October 1998.