South East Asian Currency Crises

By

Jairaj MV B14147

Kiran Mettayil Chacko B14151

Manjot Singh Saini B14152

Monish Agrawal B14156

MACROECONOMIC THEORY AND POLICY

CONTENT

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ONSET OF A CRISES

For any loan agreement there are two parties: Debtors and Creditors. Every time the blame of a financial crises falls on the shoulder of a debtor. However we fail to analyze that miscalculations have been done by both the creditors and the debtors. Similarly the East Asian Crises was caused due to shortcomings from both the economy (debtor) and IMF (lender).

In any emerging market financial crises, an economy that has been recipient of large scale capital inflows stops receiving such inflows instead faces sudden demands for the repayment of outstanding loans. This reversal of cash flows leads to financial meltdown which leads to a crises. It can be said that the onset of a crises is based on:

- Abrupt changes in international market conditions that affect the ability of debtors to repay outstanding loans, such as shifts in interest rates, commodity prices or trade conditions

- Abrupt shifts in the debtor country that cause creditors to reassess that country’s ability or willingness to service foreign debt

WHAT HAPPENED WITH ASIAN TIGERS IN 1997-98 – MIRACLE BECAME A MIRAGE

Booming Economies: In the 1990s, South East Asian economies of Thailand, Malaysia, Singapore, Indonesia, Hong Kong, and South Korea had booming states of economy with a GDP growth rate of 6%-9% per annum. The key factors for the growth were:

- Export orientation - due to inexpensive and relatively well educated labor, falling barriers to international trade, heavy inward investment by foreign companies

- Export led growth led to soaring commercial and residential real estate prices- Continued increased in wealth led exporters make bolder investments in industrial capacity- Augmented by ambition of chaebol (South Korea’s giant diversified conglomerates) - Huge infrastructure projects by the government - Encouragement by government to private businesses to invest in certain sectors in lieu with national

goalsThese economies moved from low technology manufactured export activities to high technology products. The outward oriented industrialization strategy depended fundamentally on four core macroeconomic policies:

- High rates of government and private savings- Reliance on private ownership in the industrial sector- Low inflation rates and restrained domestic credit policies- Convertible currencies, with low or zero black market premiums on foreign exchange

From Boom to Bane:What went wrong was the financing of the extraordinary growth mission plan with borrowed money. A sophisticated and well regulated financial services system is required when the production process becomes more complex and connected with world economy. With the growth in the economies, the Asian tigers were not able to effectively regulate and supervise their financial services. Hence they became vulnerable to external financial shocks. The high foreign capital inflows lead to appreciating real exchange rates, rapid expansion of bank lending thus making the economies more vulnerable to reversal in capital flows. The key factors for the crises were:

- Extremely high annual capital inflows of ~6% of GDP in 1990-96 in the five economies – Indonesia, Korea, Malaysia, Philippines and Thailand

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- Maintenance of exchange rate with little variation by the government, led central banks to absorb the risk of exchange rate movements on behalf of the investors which encouraged high capital inflow especially with short term maturities. Pegging local currency to USD increased the size of dollar loans burden when the local currencies started to depreciate against USD.

- Exchange rates appreciated in real terms as the capital inflows put upward pressure on the prices of nontradables. This raised borrowing costs leading companies to default on debt payments.

- Export growth measured in USD, began to slow in the mid-1990s and then dropped sharply in 1996- Domestic bank lending expanded rapidly throughout the region- Rising share of foreign borrowing was in the form of short term debt- Heavy investments in infrastructure lead to surplus capacity moreover such investment came at the cost

of heavy foreign imports as well. The growing imports started building up balance of payment deficits.

There were two reasons for it:- Unfavorable Macro developments – Capital inflows, real exchange rate appreciation- Unfavorable Micro developments – Credit expansion, financial regulation and supervision

In economic terms, the primary reason why markets fail in this way is due to collective action. The collective action of foreign creditors sparked the crises which led to withdrawal of capital from the region and mounting pressure on exchange rate.

CRISES AFTERMATH

The crises engulfed all the East Asian Tigers, due to:- Common causes: movements in the yen-dollar rate and other terms of trade shocks- Spillover effects: through trade and financial linkages- Contagion effects: Crises in one country served as a “wake up call” and forced market recognition of

similar financial and institutional weaknesses in the crises countries

To counter the crises governments intervened in the foreign exchange markets to defend the rate coupled with short lived hikes in interest rates and adopting floating exchange rates. However these initial responses failed to restore investor confidence and capital outflows; leading to seek support from the IMF. The Fund’s adjustment programs were focused on restoring investor confidence specific to each country. The key initiatives were:

- Strengthening the financial sector, and improving the efficiency of financial intermediation- Improving the functioning of markets including by breaking the links between business, banks and

government- Enhancing transparency with regard to the disclosure of key economic, financial and corporate sector

information- Tightening the social safety net

IMF: WHITE KNIGHT OR DARK KNIGHT

The original charge of the IMF was to lend money to member countries that were experiencing balance of payments problems, and could not maintain the value of their currencies. The idea was that the IMF would provide short term financial loans to troubled countries, giving them time to put their economies in order. As a result of the Asian crisis, in late 1997 the IMF found itself committing over $110 billion in short term loans to three countries; South Korea, Indonesia, and Thailand.

As with other aid packages, the IMF loans come with conditions attached. The IMF is insisting on a combination of tight macro-economic policies, including cuts in public spending and higher interest rates, the

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deregulation of sectors formally protected from domestic and foreign competition, and better financial reporting from the banking sector. These policies came at a cost to the Asian Tigers:

- Tight macro-economic policies are inappropriate for countries that are suffering not from excessive government spending and inflation, but from a private sector debt crisis with deflationary undertones; the tight policy increased the short term interest rates putting pressure on debt repayments

- It is said the IMF created a moral hazard, it arises when people behave recklessly because they know they will be saved if things go wrong. By providing support to these countries, the IMF is reduced the probability of debt default, and in effect bailed out the very banks whose loans gave rise to this situation.

With continued capital outflows and falling exchange rates, the countries experienced much deeper recessions than projected. This reflected mainly a collapse in domestic spending, especially private investment. The countries underwent enormous current account adjustments, associated mainly with sharp drops in imports.

LESSONS LEARNT FROM THE CRISES

The East Asian crises came as a surprise to everyone and highlighted the risks associated with doing business in developing countries. The euphoria of growth was shattered by the crises. However, lessons are learnt from history, the crises made academicians think on what went wrong and what could have been to prevent it. In simple terms lessons we can learn from the crises are:

1. Preventing or reducing the risk of crises: At national level policiesa. Avoid large current account deficits financed through short-term, unhedged capital inflows : this

can be done by securing adequate foreign exchange reserves, maintaining sound fiscal and monetary policy, adopting a viable exchange rate regime and establishing an orderly capital account liberalization

b. Aggressively regulate and supervise financial systems to ensure that financial institutions manage risks prudently : Improve information transparency and introduce limited deposit insurance along with allowing prudential regulations as financial safeguards and cushions

c. Erect an incentive structure for sound corporate finance to avoid high leverage and excessive reliance on foreign borrowing : Promote better information disclosure and establish good corporate governance

2. Managing crises:a. Mobilize timely external liquidity of sufficient magnitude : Restore market confidence and reduce

moral hazard problemsb. Do not adopt a one-size-fits-all prescription for monetary and fiscal policy: Adopt appropriate

monetary and fiscal policy contingent on the specific conditions of the economyc. Bail-in private international investors : Impose official stand stills and in extreme cases, allow

involuntary private sector involvement3. Resolving the systemic consequences of crises

a. Move swiftly to establish resolution mechanisms for impaired assets and liabilities of banks and corporations : Establish procedures for bank exits, recapitalization and rehabilitation along with establishing frameworks for corporate insolvencies and workouts

b. Cushion the effects of crises on low-income groups through social policies to ameliorate the inevitable social tensions: Strengthen social safety nets to mitigate social consequences of crises

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THAILAND

Thailand is a country at the centre of the Indochina peninsula in Southeast Asia. Thailand experienced rapid economic growth between 1985 and 1996 —averaging 9.8% annually, becoming a newly industrialized country and a major exporter. Manufacturing, agriculture, and tourism were leading sectors of the economy.

Many different factors contributed to the rapid growth of Thailand’s economy from 1985 to 1996. Low wages, policy reforms that opened the economy more to trade, and careful economic management resulting in low inflation and a stable (fixed) exchange rate. These factors encouraged domestic savings and investment and made the Thai economy an ideal host for foreign investment. Foreign and domestic investment caused manufacturing to grow rapidly, especially in labor-intensive, export-oriented industries, such as those producing clothing, footwear, electronics, and consumer appliances. These industries also benefited from a tremendous expansion in world trade during the 1980s. As industry expanded, many Thai people who previously had worked in agriculture began to work in manufacturing, slowing growth in the agriculture sector. Meanwhile, manufacturing growth spurred the expansion of service sector activities.

The graph below shows the growth of Thailand’s GDP from 1985 to 2014

The graph below depicts the growth rate of GDP of Thailand from 1985 to 2000

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BEGINNING OF THE CRISIS

Prior to the crash as mentioned above the Thailand’s economy was performing exceedingly well and became a darling of the economists and journalists. It was among the first Southeast Asian countries to overcome the economic downturn of the mid-1980s. It was able to attract enormous inflows of foreign investment especially from East Asia, and the economy boomed. Unfortunately, the episode was also characterized by a bubble and massive speculation, where investments were made with little regard to sound and supportive economic fundamentals. Hence the pressure increased on Thailand's currency, the baht, in 1997, the year in which the economy contracted by 1.9%, leading to a crisis that uncovered financial sector weaknesses and forced the  Thai administration to float the currency. The baht was pegged at 25 to the US dollar from 1978 to 1997; however, the baht reached its lowest point of 56 to the US dollar in January 1998 and the economy contracted by 10.8% that year, triggering the Asian financial crisis.

REASONS THAT LED TO THE CRISIS

The crisis in Thailand stemmed primarily from large current account deficit making the currency vulnerable to speculative attacks. Thailand’s deficit was 8 percent of GDP in 1995; 7.9 percent in 1996 and 1997 (Far Eastern Economic Review, January 15 1998). And the export growth rate decreased by 23.5 percent between 1995 and 1996. The deficits caused the country to rely heavily on external borrowing.

Secondly, excessive external debt, in 1997 the International Monetary Fund (IMF) estimated that Thailand’s external debt was about $U.S.99 billion i.e. about 55 percent of GDP. The majority of this debt was privately incurred and this large external debt sharply lifted the country’s debt service ratio from 11.4 percent in 1994 to 15.5 percent in 1997

Thirdly, the collapse of the property sector: The Thailand’s property market boomed started in the late 1980’s. With the liberalization of international capital flows in 1993 this sector grew rapidly. By 1995, an oversupply of housing emerged, expanding into a major problem. With loans increasingly becoming more expensive and hard to get under the Bank of Thailand’s squeeze on lending, the property sector began to collapse in 1996. The property sector’s debts totaled around 1,000 billion baht in 1996. The slump in the property sales market and lending squeeze worsened the developers’ cash flow troubles and defaults on interest payments. As a

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consequence many finance companies and small banks faced liquidity problems, with 16 finance companies suspended in June 1997, and another 42 in August 1997. By December 1997, 56 finance companies were closed permanently.

Fourthly, exchange rate mismanagement, with a fixed exchange rate and the liberalization of international capital flows, foreign money poured into Thailand between 1993 and 1996. As a result the Thai baht became overvalued against other currencies, partly slowing down growth in exports in 1996. Hence the speculators attacked the baht in February and May 1997 and in order to defend the currency, the Bank of Thailand used official foreign reserves. The net result being that official foreign reserves fell from $U.S.39 billion in January 1997 to $U.S.32.4 billion in June 1997. Additionally, the Bank of Thailand sold $U.S.23.4 billion of the reserves on the forward market. In July 1997, 12 the Bank of Thailand had to replace the fixed exchange rate with a “managed float”, as it could no longer tap the reserves. The exchange rate for the baht has fallen steadily since then from 25.8 baht to the $U.S. to around 40 Baht to the $U.S. currently, with the Baht reaching 50 Baht to the $U.S. before settling at its current level. The mismanagement of the exchange rate system has been cited as evidence of central bank incompetence (Thammavit, 1998).

Finally, political instability, poor economic policies and short sighted policy making were also some of the major reasons behind the crisis

EFFECT OF THE CRISIS

The crisis led to huge devaluation of Thai currency Baht, which made the foreign debt too expensive. It led to the contraction of the economy of Thailand in the year 1997 by as much as 10%. The exports nose-dived and this created a huge current account deficit and the foreign exchange reserves of Thailand virtually evaporated. It hence necessitated IMF-led bailouts.

Finally it led to restructuring of the Thailand’s economy and the financial sector.

As mentioned earlier the IMF-led bailouts did not come unconditional. The IMF lent Thailand $17 billion on 11 August 1997 but the support was conditional on a series of economic reforms, called the "structural adjustment package" (SAP). The SAPs called on crisis-struck nations to reduce government spending and deficits, allow insolvent banks and financial institutions to fail, and aggressively raise interest rates. The reasoning was that these steps would restore confidence in the nations' fiscal solvency, penalize insolvent companies, and protect currency values.

It called for Thailand’s government to pass laws relating to bankruptcy (reorganizing and restructuring) procedures and establish strong regulation frameworks for banks and other financial institutions.

THAILAND’S ECONOMY NOW

A decade on from the financial crisis of 1997, Thailand finds itself in the midst of another crisis, this time a political one. Although the economy has been suffering from a downturn in business confidence in the wake of the September 2006 military coup, Thailand's economic fundamentals are nevertheless generally strong. Indeed, rather than battling the markets to prop up the baht, the Bank of Thailand (BOT, the central bank) has been under pressure to weaken it. In order to do so, in late 2006 the BOT imposed controls on the inflow of capital.

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The baht now stands at a nine-year high of around Bt34.5:US$1 on the local market, and on the offshore market it has risen to Bt32.3US$1.

The country's external accounts are far healthier: the current account has been in surplus every year since 1997 except 2005; foreign-exchange reserves have soared to US$71bn, up from the 1997 low of US$26bn reached when the BOT gave up its costly efforts to keep the baht fixed to the dollar; and external debt levels have dropped sharply, with most of the private sector's short-term debt taking the form of trade credits rather than loans, a reversal from the pre-1997 situation.

The banking sector has also recovered well, with NPLs dropping to around 4-5% of total outstanding loans--a decade ago the ratio was close to 50%. A process of consolidation in the banking sector has also been under way since 2004, and regulatory standards and bank lending practices have improved markedly.

INDONESIA

THE CRISIS

The Crisis in Indonesia was largely due to the contagion Effect of the Asian Financial Crisis started on July 2 1997, when the Thai Government burdened with huge financial debt decided to float its currency (which was earlier pegged to Dollars). This monetary shift was aimed at stimulating export revenues but proved to be in vain. It soon led to a contagion effect in other Asian countries as foreign investors - who had been pouring money into the 'Asian Economic Miracle countries' since a decade prior to 1997 - lost confidence in Asian markets and dumped Asian currencies and assets as quickly as possible.

Indonesia was the far worst affected economy in the Asian crisis, with the severity of the crisis coming as a surprise to many observers. In fact very few predicted the crisis in Indonesia even after the devaluation of the Thai bhat in July 1997. It was instead argued that the crisis would not have not have any significant impact on Indonesia because of its sound macroeconomic fundamentals. Indonesia enjoyed the highest economic growth in South East Asia, low inflation, a relatively modest current account deficit, rapid export growth and growing international currency reserves. Foreign investors initially kept confidence in Indonesia’s ability to weather the economic storm (as it had in 1970s and 1980s). However this time it became the hardest hit country as the crisis not only had economic but also far reaching political and social implications.

MAJOR CAUSES OF CRISIS IN INDONESIA

Indonesia’s Macroeconomic vulnerability to crisis

The real effective exchange rate of a country is determined is determined by its capital inflows and exchange rate regime. A stable exchange rate attracts foreign investors. Before the crisis, the exchange rate regime in Indonesia was managed by its central bank which allowed the exchange rate to float within a band around a target. Although Indonesia widened the exchange rate intervention band from 0.5% in 1992 to 8% in 1996, fluctuations in the nominal interest rates were limited to around 4% annually, indication that the central bank was able to control the exchange rate movements. The stable Indonesian exchange rate appealed to foreign investors and led to a large increase in capital inflows which contributed to a slight appreciation in real effective exchange rates in 1996.

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The exchange rate regime worked relatively well with a stable or even depreciating US dollar, but the regional currencies appreciated slightly along with the US dollar in 1996. This appreciation was accompanied by the entry of new competitors such as China, Vietnam, and India, which liberalized their economies in 1990s and became successful exporters of goods. As a result of these factors, export growth decreased for Indonesia from an average 13% between 1990 and 1995 to 10% in 1996(however, this was lower than in most of the remaining ASEAN countries)

The slowdown in the export growth aggravated the existing trade imbalances, fuelling larger current account deficits in the region as a whole. However, for Indonesia, despite the real effective exchange rate appreciation, new competitors and an oversupply of certain important export goods the current account deficit remained at a stable 2.5% of GDP between 1990 and 1996. It was not the size of Current account deficit which precipitated the crisis, but the way it was financed. Long term capital inflows, such as foreign direct investment, are relatively stable and tend to remain in a country once they have been introduced. On the other hand, short term dents increases the vulnerability to shifts in investor willingness. High Indonesian interest rates encouraged short term capital inflows. The Government at that time wanted to curb an overheating economy by raising the interest rates. However the short term capital inflows limited the effectiveness of tight monetary policy. Therefore the restrictive economic policy through higher interest rates failed, since capital inflows increased domestic liquidity and thereby economic activity. Also Indonesia restricted to finance its current account deficit through FDI due to political reasons and thus went for large short term capital inflows. High short term debts to international reserves increased the risk for a country of not fulfilling its debt payments in the event of a creditor run. In Indonesia, the ratio of short term external debts to international reserves was high, particularly compared to other countries in 1996

Another related factor of financial fragility was ratio of M2 to international reserves. If a currency crisis or financial panic occurs, all liquid money could potentially be converted into foreign exchange. The ratio between M2 (broad money supply) and international reserves was particularly high for Indonesia (6.5)

Effect of Investor’s Behavior

Japan, which was the major lender to Indonesia (accounted for 35% in Indonesia) had been in an economic recession since 1991 and the recession worsened in early 1997. The Japanese banking sector was severely hurt by the recession and many banks experienced capital losses and were required to rebalance their loan portfolios. The Japanese banks were the first ones to pull out of South East Asia and this withdrawal exacerbated economic condition in Indonesia.

In addition, imperfect information may have led investors to consider that Indonesia and Thailand had similar problems, causing them to withdraw their Indonesian funds. Although Indonesia had better economic fundamentals than Thailand, the low ratios of international reserves to short term debts or to broad money supply were troublesome features of the economy. The crisis in Thailand may have acted as a wak up call for international investors to reassess Indonesia’s macroeconomic performance.

Changes in International financial markets also facilitated the contagion effect. The IMF’s first recommendation during the Asian crisis was to shut down the operations of numerous financial institutions in Thailand and Indonesia. 16 banks in Indonesia were closed in 1997 and another 7 in 1998. The IMF’s recommendation to close insolvent financial institutions, not realizing hat there was no depositor’s insurance, sent a signal to investors and depositors elsewhere that there was not enough international support to protect their investments.

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This resulted in a panic and bank run, which continued until January 1998, when Indonesian authorities announced a depositor guarantee

The lost in investor’s confidence led to a sudden capital flight from the country which led its national currency, rupiah to depreciate significantly against US dollars. The depreciation was soon followed by a national banking crisis and ended up as a national economic crisis. Through the rupiah depreciation and higher interest rate (as the monetary authority’s direct response in that time in order to stop capital flight), the crisis hit first middle and high income groups such as current employees in the financial/ banking sector and large scale industries which strongly dependent on credits from bank or other financial institutions and imports. After several months, domestic inflation started to increase, and this accompanied with the increase in unemployment due to many laid off employees in crisis-affected firms than resulted in a significant increase in the poverty rate in 1998.

Theoretical Impact of Currency Depreciation

Transmission Channels of the Effects of the 1997/98 Crisis on the Indonesian Economy.

Theoretically, the direct impact of a currency depreciation will be mainly on export and import of the particular country (Figure 1). By assuming other factors constant, export, and hence, production and employment or income in the exporting firms/sectors and in their backward as well as forward linked firms/sectors will increase. This is the export effect of a currency depreciation. On the import side, domestic prices of imported consumption and non-consumption goods will also increase. In the case of non-consumption goods, i.e. raw materials, capital and intermediate goods, components/ spare parts, as a response to higher prices (in national currency) of these imported goods, two scenarios are possible: (1) imports decline and, consequently, total domestic production and employment also drop, or (2) imports may stay constant, but it means thus domestic production cost will increase and finally it will result in higher domestic inflation. This is the import effect of a currency depreciation.

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Besides the above effects, a national currency depreciation also makes the value in national currency of foreign debts (in foreign currency against which the national currency has depreciated) owned by domestic firms to rise. Many highly foreign indebted domestic firms will face a serious financial crisis. If many of them have to reduce their production or even collapse, domestic total production and employment will then further decline. This can be called as the foreign debt cost effect of a national currency depreciation.

Indonesian Scenario

So, in this 1997/98 crisis case, the key transmission channels through which the crisis affected the Indonesian economy were changes in export and import volumes and cost (in national currency) of foreign debts. With respect to the impact on poverty, the next transmission channel were changes in employment/income, and inflation.

When pressures on the Indonesian rupiah became too strong, the currency was set to float freely starting from August 1997. Soon it began depreciating significantly. By 1st January 1998, the rupiah's nominal value was only 30 percent of what it had been in June 1997. In the years prior to 1997 many private Indonesian companies had obtained unhedged, short-term offshore loans in dollars, and this enormous private-sector debt turned out to be a time bomb waiting to explode. The continuing depreciation of the rupiah only worsened the situation drastically. Indonesian companies rushed to buy dollars, thus putting more downward pressure on the rupiah and exacerbating the companies' debt situation. It was certain that Indonesian companies (including banks; some of which were known to be very weak) would suffer huge losses. New foreign exchange supplies were scarce as new loans for Indonesian companies were not granted by foreign creditors. As the government of Indonesia was unable to cope with this crisis it decided to seek financial assistance from the International Monetary Fund (IMF) in October 1997.

IMPACT OF CRISIS

Arrival of IMF

The IMF provided a bailout package totaling USD $43 billion to restore market confidence in the Indonesian rupiah and demanded some fundamental financial reform measures: the closure of 16 privately-owned banks, the winding down of food and energy subsidies, and it advised the Indonesian Central Bank (Bank Indonesia) to raise interest rates. But this reform package turned out to be a failure. The closure of the 16 banks triggered a run on other banks. Billions of rupiah were withdrawn from saving accounts, restricting the banks' ability to lend and forcing the Central Bank to provide large credits to the remaining banks to avert a complete banking crisis. Moreover, the IMF did not try to curb Suharto's system of patronage that was damaging the country's economy and undermining the IMF accord. This patronage system was Suharto's tool to maintain power; in exchange for political and financial support, he gave powerful positions to his family, friends and enemies. Other developments that were negatively impacting on Indonesia towards the end of 1997 were a serious El-Nino drought (causing forest fires and bad harvests) and increased speculation about Suharto's deteriorating health (causing political uncertainties). Gradually, Indonesia was heading towards a political crisis.  

A second agreement with the IMF was needed as the economy was continuing its downward spiral. In January 1998 the rupiah lost half of its value within the time-span of five days only, causing Indonesians to hoard food. This second IMF agreement contained a detailed 50-point reform program, including provisions for a social

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safety net, a gradual phasing out of certain public subsidies and the tackling of Suharto's patronage system by ending monopolies of a number of his cronies. However, reluctance of Suharto to implement this structural reform program faithfully, did not improved the situation.

A third agreement with the IMF was signed in April 1998. The Indonesian economy and social indicators were still showing worrying signs. But this time, however, the IMF was more flexible in its demands than on previous occasions. For instance, large food subsidies for low-income households were granted and the budget deficit was allowed to widen. But the IMF also called for the privatization of state-owned companies, faster action on bank restructuring, a new bankruptcy law and a new court to handle bankruptcy cases. It also insisted on a closer monitoring of its implementation as recent experiences had shown that the Indonesian government was not fully committed to the reform agenda.

Start of recovery

The removal of Suharto from presidency and new political system catalysed a fourth agreement with the IMF. It was signed in June 1998 and allowed the budget deficit to widen further while new funds were pumped into the economy. Within the timespan of a couple of months there were some signs of recovery. The rupiah began to strengthen from mid-June 1998 (when it had fallen to 16,000 rupiah per dollar) to 8,000 rupiah per dollar in October 1998, inflation eased drastically, the Jakarta stock exchange started to rise and non-oil exports started to revive towards the end of the year. The banking sector (center of the crisis) remained fragile as the number of non-performing loans were high and banks were very hesitant to loan money. Moreover, the banking sector had caused a sharp increase in government debt as this debt was primarily due to the issuance of bank restructuring bonds. But, albeit fragile, the country's economy improved gradually through 1999, partly due to an improving international environment which caused a rise in export revenues.

Indonesian GDP and Inflation 1996-1998

Conclusion

Indonesia together with South Korea were among the most severely affected ones. The Indonesian economy had plunged into a deep recession in 1998 with overall growth at minus 13.7 per cent. The crisis also led to a significant drop in income per capita to drop, and a significant increase in poverty rate. There were three main reasons why the rupiah depreciation had caused a serious decline in Indonesia’s aggregate output. First, despite the fact that Indonesia has adopted import substitution strategy during the New Order era (1966-1998), Indonesia, especially the manufacturing industry, has been increasingly dependent on imported capital and intermediate goods, components and spare parts, and some processed raw materials. So, the rupiah depreciation prevented many export-oriented firms from gaining better world price competitiveness, on one hand, while, on the other hand, many domestic market-oriented firms had to close down or to cut their production volume

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because they could not purchase any more very expensive imports. Second, many firms, especially conglomerates, during the New Order era had borrowed a lot money from foreign capital markets; mostly were short-term loans. They went bankrupt when rupiah depreciated and many other firms which had business relations with them were also in trouble. Third, the national banking sector was also collapsed. By the end of 1997 16 commercial banks were closed, and access to credit became very difficult and interest rate increased significantly. This has contributed significantly to output contractions in many sectors in Indonesia.

Economic variables of Indonesia during crisis

SOUTH KOREA

THE CRISIS BEGINS

In November 1997, Korea was hit by a currency-cum-banking crisis and an official assistance from the IMF helped them avoid a sovereign default. Let us see how the crisis began in first place. In 1990, Korea’s current account balance started to deteriorate because of rising inflation, appreciation of the Korean won, and the recession of the world economy. In order to finance the growing current account deficits, the government encouraged capital inflows. In 1993, the Korean government also announced a blueprint for financial sector liberalization that deregulated restrictions on asset and liability management of financial institutions. This led to an increase in the short-term foreign currency debts of financial institutions. Korea’s external debt rose from $89 billion in 1994 to $174 billion in 1997. The government by its policies discouraged long-term foreign borrowing by business firms as it required detailed disclosure on the uses of the funds as a condition for its permission. This incentivized banks and business firms to finance long-term investments with short-term foreign borrowings. These short-term external debts accounted for 61% of total external debts in 1996. There was proliferation of merchant banks owned by Chaebols, the South Korean family owned conglomerates which were heavily engaged in borrowing cheap short-term

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Japanese funds to finance mostly long-term investment projects. In order to stay in business Commercial banks also borrowed from abroad at short-term maturities. The mismatch problems stemmed significantly from weak prudential supervision. The accounting and disclosure standards expected of financial institutions were below international best practices, and market-value accounting was not widely practiced. Due to weak financial supervision and high chaebol dependence on bank financing, risk was concentrated on banks. In spite of all the risks associated with these mismatches, Korea was still one of the world’s fastest growing economies with an average annual growth rate of 7-9% and a modest inflation rate of about 5% a year for the three years leading up to the crisis. The ratio of its foreign debt to GDP was less than 30%.

Given these situations, there were at three major developments that served as triggers for the Korean financial crisis.

1. The movement of the US dollar: Most of the foreign borrowings were made on the assumption that US dollar will stay weak thereby making Korea’s exports more competitive. The weakening of Japanese Yen against US Dollar made them recall foreign loans putting a strain on foreign exchange reserve of Korea.

2. Bailout of ailing Chaebols by the government3. Usage of foreign exchange reserves by Korean banks to service short

term debts.

HOW THE CRISIS WAS ADDRESSED?

The crisis in Korea was not a traditional balance of payment crisis due to excessive external debt. It was a liquidity crisis which required a rapid infusion of hard currency reserves. This happened due to serious mismatches in the currency and in the capital structure in the balance sheets of the financial and non-financial sectors of the economy. IMF promised disbursement of $58 billion over more than two years until 2000, with each installment conditioned upon the progress Korea was to make in structural reforms and the further tightening of its monetary and fiscal policies. Foreign banks judged these amounts to be altogether inadequate, even in terms of meeting the nation’s short-term obligations. Given the large amount of short-term obligations and the precarious level of official foreign reserves, this judgment became a self-fulfilling prophecy. As rollovers were refused, the limited foreign reserves were rapidly depleted. Foreign creditors further accelerated the withdrawal of their funds from Korea, pushing the country to the verge of a sovereign default in less than two weeks after the initial agreement was signed. Korea was able to avoid this worst possible situation only with the help of the United States.

In order to bring order back into the Korean economy, reforms were undertaken to achieve two overriding goals: (1) to reduce the likelihood of a similar crisis in the future by cleaning up the balance sheets of financial institutions

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and (2) to evolve a financial system that can best help the nation resume growth with stability. The reforms were primarily undertaken as (a) reforms designed to strengthen the legal and regulatory infrastructure, (b) reforms implemented to rehabilitate the financial sector, (c) reforms aiming at strengthening prudential regulation, (d) reforms to reduce moral hazard, (e) reforms to strengthen the corporate governance of financial institutions.

a. Strengthening legal and regulatory infrastructure: The first step in comprehensive financial-sector reform was laying out a statutory and regulatory framework to implement necessary reforms. Thirteen financial bills, including a bill to establish a consolidated financial supervisory authority, were enacted. The Financial Supervisory Commission (FSC) was established and the existing separate financial supervisory organs were merged into a consolidated Financial Supervisory Service (FSS) to serve as an administrative body for the FSC

b. Rehabilitating financial institutions: Korea’s banking sector had two major problems: inadequate capitalization and poor-quality assets. This was due to the large number of chaebol bankruptcies that damaged banks’ balance sheets carrying many non-performing loans. In order to address these problems, the government had to step in with public funds. Loans with arrears more than 3 months were constituted as Non-performing loans. Also policy regulations were carried out to control the functioning of merchant banks.

c. Strengthening prudential regulations: Under the terms agreed with the IMF, the Korean government strengthened prudential regulation by introducing a forward-looking approach in asset classification, taking into account the future performance of borrowers in addition to their track record in debt servicing. The asset classification standards were further strengthened with the introduction of the loans classification as non-performing when future risks are significant even if interest payments have been made without a problem. Also, there were regulations on short-term foreign borrowing by banks, strengthening limits on bank lending to large borrowers, and strengthening disclosure requirements for financial institutions.

d. Reducing moral hazard: The most significant institutional reform in this area was the introduction of partial deposit insurance. Before the crisis, depositors and investors had typically assumed that their assets were fully protected by the government. Partial protection introduced market discipline by providing incentives to depositors to seek out healthy institutions.

e. Strengthening corporate governance of financial institutions: In order to strengthen the governance of financial institutions many measures have been taken. They include allowing foreigners to own commercial banks improving governance of financial institutions and strengthening the rights of commercial

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bank minority shareholders, and raising the limit of bank ownership of domestic residents from 4% to 10%.

As a result of extensive restructuring of the financial sector, many insolvent or very weak institutions have been weeded out. In addition, both the capital adequacy ratios and profitability of most of the nation’s financial institutions have greatly improved.

LESSONS FROM THE KOREAN CRISIS

1. Korea’s decision to liberalize short-term capital flows ahead of long-term capital flows was a serious mistake. Korea should have realized that short-term capital flows are more volatile than long-term by liberalizing short-term before long-term flows, Korea accumulated far too much short-term liability, which led o uncontrollable mismatches in maturity and currency.

2. Superiority of a pure floating exchange rate system over a managed floating system. Under a managed floating system, the market mechanism is hindered from correcting trade or current account imbalances. In periods leading up to a full-fledged crisis, policymakers often fear that if they start making big adjustments, at once the exchange rate will freefall, leading to a situation beyond their control which encourage speculative attacks on the currency.

3. Need for prudential supervision and policymakers to regulate the economy.

4. To maintain the confidence of foreign investors, transparency on the business and government level is critical.

5. Need to develop long-term capital markets in Korea. As long as long-term capital markets do not develop locally in Asia, Asian countries are bound to suffer to some degree both maturity and currency mismatches. The only way to eradicate this problem is to find ways and means to accelerate development of capital markets in Asia and other emerging markets.

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Radelet; NBER working paper7. The East Asian Crises : Macroeconomic Developments and Policy Lessons – by Kalpana Kochhar,

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Decline in the Value of the Baht: Roger Graham, Raymond King and Jack Bailes.20. Thailand’s Capitalism: The Impact of the Economic Crisis by Kevin Hewison21. Tradingeconomies.com: http://www.tradingeconomics.com/thailand/housing-index 22. encyclopedia.com: http://www.encyclopedia.com/topic/Thailand.aspx 23. Crisis and Recovery ADBI

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