Abstract

The East Asian financial crisis has been one of the most controversial issues since it

was precipitated in the mid of 1997. The debate included various aspects such as the

causes of the crisis the measures imposed by the IMF and even the " Help yourself"

package adopted by the Malaysian government. There are two main arguments about

the causes of the crisis. The first attributed the principal causes to the existence of

fundamental weaknesses and Moral hazard in the Asian economies. Whereas the

second attributed the main causes to financial panic as well as the absence of lender

of the last resort. In addition both arguments included the political instability and

policy mistakes resulted from government intervention in the economy as one of the

causes. Also the role of the IMF in handling the crisis was heavily criticized to the

extent that some economists contended that the IMF measures made the crisis worse

rather than better. In the mean time, the controversy included the efficiency of the

capital controls imposed in Malaysia to overcome the crisis. In this paper I will

review the main causes of the crisis, as well as comparing between the IMF measures

and the Malaysian "Help yourself strategy". Finally, I will try to address some of the

lessons that we have learned so far from the Asian crisis.

Introduction

The East Asian financial crisis has been one of the most observable issues

since it was triggered in mid 1997. It has been the sharpest financial crisis to hit the

developing world since the debt crisis of 1982 (Radelet and Sachs, 1998). Also, it

was described as the most serious financial and economic crisis in the world since the

Second World War (McNeill and Bockman, 1998). The crisis hit the Asian Tigers or

economies with the highest growth rates in the world, at that time. Additionally the

crisis, as contended by Radelet and Sachs (1998), prompted the largest financial

bailouts in the history.

In fact, the Asian crisis was triggered subsequent to a decade of unusual success for

the Asian economies. The international financial community, before the crisis, largely

invested in the Asian countries recognizing them as the most rapidly growing

economies in the world. According to the Institute for International Finance, the

capital inflows to the Asian five increased from average of 1.4% of GDP between

1986 and 1990 to 6.7% between 1990 and 1996. The highest capital inflows were

directed to Thailand with average of 10.3% of GDP in the period from 1990 to 1996.

Most of these inflows came from offshore borrowings by banks and finance

companies.

In essence, these high proportions of capital inflows resulted mainly from the new

policies of highly integrated and liberalized international capital markets.

Additionally, low interest rates in the United States and Japan facilitated the flow of

these investments towards the emerging markets in the Asian region. Finally, high

growth rates realized by foreign investors in the Asian region increased their

confidence in these emerging economies. Furthermore, there were some internal

factors contributed to these massive capital inflows such as the lack of supervision

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and deregulation allowed domestic banks and finance companies to overborrow from

foreign banks to finance local projects, the special incentives given by the

governments of the region to promote investing in their countries, and finally the

pegged exchange rate policy and its relative stability, regardless of its drawbacks,

decreased the uncertainty and risk perceived by foreign investors.

Suddenly, and unpredictably, these capital inflows were reversed. According to the

Institute for International Finance as quoted in Radelet and Sachs (1998), the net

private inflows dropped from $93 billion to - $12.1 billion, a swing of 11% of GDP.

Therefore, Radelet and Sachs (1998) stated, "In this sense, the Asian Crisis can be

understood as a 'crisis of success', caused by a boom of international lending

followed by a sudden withdrawal of funds". Another factor that contributed to the

interestingness of the crisis is its unpredictability. "The crisis was largely

unanticipated. Although a small number of market participants were concerned ex

ante, the vast majority of players did not view the southeast Asian economies as

bubbles waiting to burst"1.

In fact, Radelet and Sachs (1998) cited some evidence of the unpredictability of the

crisis such as, the strong capital inflows through 1996 and in most cases till mid

1997, Standard and Poor's and Moody's ratings of sovereign bonds remained

unchanged and did not signal any doubts of crisis. Finally they stated that the IMF

Executive Board expressed some concerns about the Asian economies, but in the

context of overall optimism. The only indicator of the crisis, as argued by them, was

the stock prices before the crisis. The Thai main index fell about 60% between 1996

and mid 1997. The prices in the Korean stock exchange, also, slumped sharply in

early 1997. In Malaysia the stock market began to slump in March 1997.

1 The Onset of the East Asian Financial Crisis, Steven Radelet and Jeffrey Sachs (1998).

3

What Caused The Asian Financial Crisis?

In fact the answer to this question is quite controversial. On one extreme some

economists attributed the main causes to the existence of structural problems and

fundamental weaknesses in the Asian economies such as current account deficits,

maturity mismatch, moral hazard, crony capitalism and price bubbles "As it turned

out in 1997 Asian economies did indeed experience a severe financial crisis. And with

the benefit of hindsight, several weaknesses in their economic structures--some

shared by Latin American countries that had gone through crisis--became apparent" 2.

At the other extreme, others attributed the principal causes to financial panic, highly

liberalized financial systems as well as the absence of lender of the last resort "A

combination of panic on the part of the international investment community, policy

mistakes at the onset of the crisis by Asian governments, and poorly designed

international rescue programs turned the withdrawal of foreign capital into a full-

fledged financial panic, and deepened the crisis more than was either necessary or

inevitable"3. In addition, both arguments included the political instability and policy

mistakes resulted from government intervention in the economy as one of the causes.

The most amazing thing in this debate is that neither of the two schools of thought

denied the rationality of the causes claimed by the other, however the debate focused

on the degree to which each group of causes mainly induced the crisis. But before

further exploring this quite interesting debate, it is useful to briefly introduce, in the

next section, how the crisis was initially emerged.

2 International Economics Paul R. Krugman and Maurice Obstfeld 5th edition, Addison Wesley (2000). 3The Onset of the East Asian Financial Crisis, Steven Radelet and Jeffrey Sachs (1998).

4

The purpose of this paper is to review the main causes of the crisis, to assess the role

of the IMF and the Malaysian strategies and finally to address some of the lessons

that we have learned so far from the Asian Crisis.

The Paper is organized as follows. Section two summarizes the precipitation of the

crisis. Section three reviews the main causes of the crisis. Section four provides a

brief explanation of the IMF and the Malaysian strategies to conquer the crisis, as

well as reviewing the main critiques to both strategies. And, finally, section five

comprises the conclusion, which addresses some of the lessons learned so far from

the crisis and its effect on the development of new international financial architecture.

The Precipitation of the Crisis

In the mid-year of 1997 the financial crisis that hit the Asian economies

(Asian five- Thailand, Indonesia, Malaysia, Korea and the Philippines) was

intensifying. The crisis started by the devaluation of the Thai currency "Baht" in the

summer of 1997. The devaluation of the Baht triggered a case of dramatic capital

flight from the Asian countries accompanied by turmoil in capital and money

markets, which eventually led to a slump in the domestic stock prices as well as a

devaluation of local currencies. The Asian governments tried to defend their

currencies by using the foreign reserves, but eventually the reserves were fully

depleted and the devaluation was inevitable.

In Principle, the Asian Crisis had gone through several stages before it turned to be a

complete financial and economic crisis. Nixson and Walters (1999) contended that it

was initially a linked series of currency crises, which had a domino effect on the

currencies of the Asian five, caused them to collapse significantly. Also Paul

Krugman (1998) wrote "However, the currency crises were only part of a broader

5

financial crisis, which had very little to do with currencies or even monetary issues

per se". As a consequence of the currency crisis investors panically withdrew out

their short-term capital to cause many bankrupts of financial institutions throughout

the region "In this sense, the Asian crisis can be understood as a 'crisis of success'

caused by a boom of international lending followed by a sudden withdrawal of

funds"4. The occurrence of this internal financial crisis had led to a dramatic decline

in the amount of credit available to different business enterprises causing them to

went bankrupt as well.

Many countries of the region such as Thailand, South Korea Indonesia and the

Philippines, Knocked the IMF doors to conquer the crisis. However it was argued that

the IMF intervention had made the crisis worse rather than better. "This was arguably

exacerbated by the intervention of the IMF, which tied the extension of international

credit lines to the imposition of a deflationary stabilization package. This in turn

generated a further crisis; one of rising unemployment, destitution and poverty"5.

Dissimilarly, Malaysia's Prime Minister Mahathir in September 1st 1998, decided to

adopt a "Help yourself" strategy, which aimed at ending the speculation against the

Malaysian currency "Ringgit"6. Accordingly, the Malaysian government imposed

controls on capital outflows, and fixed the exchange rate at MR 3.8/1 US Dollar

along with maintaining an autonomous monetary policy, which allowed them to cut

interest rates without affecting the exchange rate. In fact, the primary goal of

imposing the controls was to stop the short selling of Ringgit assets in the offshore

market. Also they were aware of possible evasions that would occur, hence they

enforced a set of regulatory actions to protect their policy against these evasions.

4 The Onset of the East Asian Financial Crisis, Steven Radelet and Jeffrey Sachs (1998). 5 Nixson, F. and Walters, B(1999) "The Asian Crisis: Causes and Consequences. 6 Prime Minister Mahathir claimed that George Soros's speculation, at that time, was the key reason of the crisis.

6

Apparently, the Asian crisis started as a currency crisis and, finally, turned out to be a

crisis of the real economy. In the next section I will review the causes of the crisis.

Fundamental Weaknesses and Structural Problems

• Current Account Deficits:

As mentioned above the first argument included the large and continuous trade

and current account deficits for the Asian countries as one of the causes. Table 1 lists

the current account deficit as a percentage of GDP for the most affected economies in

addition to China and Taiwan during the period from 1992 through 1997.

Country 1992 1993 1994 1995 1996 1997

Korea -1.70 -0.16 -1.45 -1.91 -4.82 -1.90

Indonesia -2.46 -0.82 -1.54 -4.27 -3.30 -3.62

Malaysia -3.39 -10.11 -6.60 -8.85 -3.73 -3.50

Philippines -3.17 -6.69 -3.74 -5.06 -4.67 -6.07

Thailand -6.23 -5.68 -6.38 -8.35 -8.51 -2.35

China 1.09 -2.19 1.16 0.08 0.52 3.61

Taiwan 4.08 3.52 3.12 3.05 4.67 3.28 Source of data Corsetti, G. Pesent, P. and Roubini, N. (1998) "What Caused The Asian Curreny and Financial Crisis?

Part I: A Macroeconomic Overview".

As argued by Nixson and Walters (1999) these deficits were eliminated by capital

inflows to the Asian countries. However, private short-term capital inflows

represented about 80% of these capital inflows. Moreover financial institutions at that

time used these short-term capital flows to finance long-term domestic projects.

Therefore, when the currency crisis had initially hit the Asian five, the sudden

reversal of the flow of short-term capital had exposed the maturity mismatch of the

Asian five economies, the case that contributed to increase the severity of the crisis.

7

Furthermore, Corsetti, Pesenti and Roubini (1998) stressed on current account

imbalances as being one of the main causes of the crisis. They used the US Deputy

Treasury Secretary statement in The Economist as an evidence of the significance of

current account imbalances in triggering the Asian crisis. Corsetti et al (1998) wrote,

"Lawrence Summers, the US Deputy Treasury Secretary, wrote in The Economist that

'close attention should be paid to any current account deficit in excess of 5% of GDP,

particularly if it is financed in a way that could lead to rapid reversals' By this

standard, a number of countries in our sample provided reasons for concern".

In this context and from table 1 we can observe a general deterioration of this

measure for the Asian five from 1992 to 1996, however, amazingly, this percentage

was a bit better in three of the five countries in the year of the crisis 1997 but still a

matter of concern. Corsetti et al (1998) contended that these imbalances stemmed

mainly from large trade deficits, with a relatively small role played by net factor

payments to the rest of the world, particularly in Indonesia. Also, Nixson and Walters

(1999) argued that these deficits reflected a number of interacting influences such as

the loss of competitiveness with China, which had devalued its currency by about

50%, the appreciation of the US dollar against the Yen had led to a simultaneous

appreciation of the Asian dollar-pegged currencies against the Yen, and the

stagnation of Japan during the 1990s decreased the exports from the Asian countries.

Finally, we can observe that the initial currency crisis had hit, mostly, the Asian five

which experienced high deficits during the 1990's period "In fact, as a group, the

countries that came under attack in 1997 appear to have been those with large

current account deficits throughout the 1990's; in 1997 the appreciation of the US

dollar relative to the currencies of the high-deficit countries Thailand, Malaysia,

Philippines, Korea and Indonesia reached 78%, 52%, 52%, 107% and 151%

8

respectively"7. Whereas other countries currencies such as China and Taiwan had not

been hit as severely as the Asian five. Their currencies were depreciated by 2% and

18% respectively This conclusion may support the first argument that fundamental

weaknesses like current account deficits were the main reasons of the crisis

precipitation. Nevertheless, it was argued that although the imbalances in the current

accounts set the stage for the crisis, they were not big enough to trigger such a severe

crisis.

• Banking and Financial Sectors and Deregulation problems

Krugman (1999) stated that he and most economists were wrong to explain

the Asian crisis from the perspective of conventional currency-crisis models as the

Asian crisis was mainly about bad banking and its consequences. The Asian five in

the 1990s had most of the financial intermediation occurred through the banking

sector. Most of the capital inflows from international financial community were

intermediated through the countries' domestic banks to local firms. In fact, the

banking sector in the Asian region was rapidly growing in the 1990s. However, the

poorly designed regulatory and supervision systems at that time and the fight among

this deregulated banks to obtain new market shares, facilitated a case of

overborrowing, overlending and sometimes fraudulent lending. Therefore, when local

firms during the crisis went bankrupt, domestic banks experienced large financial

problems. Corsetti et al (1998 a) argued that there was evidence that Asian banking

and financial systems were very fragile, poorly supervised and poorly regulated even

before the precipitation of the crisis.

In Indonesia the lack of compliance and enforcement had led to the evasion of

banking regulations, which were in line with Basle Committee recommendations. The

central bank in Indonesia published that in April 1996, out of total of 240 banks, 41

7 "What Caused The Asian Curreny and Financial Crisis? Part I: A Macroeconomic Overview" Corsetti, G. Pesent, P. and Roubini, N. (1998).

9

exceeded the legal limits of spending, 15 failed to meet the capital adequacy ratio,

and 12 licensed foreign exchange banks turned a blind eye to the rules on net

overnight positions. In Korea as contended by Corsetti et al (1998 a) the financial

system was in real danger because of the excessive lending to large traded-sector

conglomerates a number of which went bankrupt before the onset of the currency

crisis in 1997.

In Thailand the enforcement of commercial banking regulations limited the banking

lending ability, however in the 1990s subsequent to the financial liberalization, non-

banking financial intermediaries called "finance companies" emerged and did succeed

to evade these credit limits. In addition, these financial institutions expanded their

credits to the real estate and property sector, principally financed by foreign short-

term capital.

As a consequence, many of these public and private banks and non-banking financial

institutions faced huge amounts of non-performing domestic assets and short-term

foreign currency obligations. In the beginning of 1996 state-owned banks in

Indonesia faced a non-performing debt level of 17%. In Malaysia the overlending to

real estate and property sector (42.6% of total credits) drove up asset prices by about

25% in 1996, however, eventually the central bank put ceilings on lending to the

property sector and equity purchases in order to slowdown this growth in asset prices.

Nevertheless, Corsetti et al (1998 a) argued, "these actions were too little, too late"

Moral Hazard, Asset bubbles & Corruption

The second main cause of the Asian crisis, as claimed by the first group of

economists, is the existence of Moral Hazard accompanied by Corruption, resulting

in what is referred to as "Crony Capitalism". Nixson and Walters (1999) explained,

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"Moral Hazard arises whenever the incentives surrounding actions are distorted by

the existence of explicit or implicit guarantees against loss". In this sense we can

deduce that there was a wide spread belief amongst creditors, in the Asian region, that

they would be bailed-out if their investments went bad. Therefore, some economists

(Nixson and Walters 1999 and Krugman 1998) claimed that the currency crises hit

economies with more exposure to the risk of self-fulfilling crisis, than had been

previously assumed. This is simply because a combination of Moral Hazard and

Corruption "Crony Capitalism" had encouraged excessive risky investments in lower-

productivity projects.

In his paper Krugman (1999) has given an example to explain the logic of moral

hazard for guaranteed intermediaries. He assumed that an owner of an intermediary

with a capital of $100 million is facing two investment scenarios. The first yields a

certain present value of $107 million, whereas the other will either yield $120 million

with a probability of 50% or $80 million also with a probability of 50%. This implies

that the expected value of this risky investment is $100 million. Krugman explained

that moral hazard in this case would induce the owner of the financial intermediary to

pursue the risky investment, even though it has lower expected profit, as he knows

that while he can capture the $20 million profit in the good state, he has nothing to

lose if the economy turned to be in the bad state. Krugman then stated, "And this

distortion of investment decisions produces a deadweight soial loss: the expected net

return on the invested capital falls from $7 million to zero". Similarly, Mckinnon and

Pill (1996) have stressed on the notion that moral hazard can lead to excessive

investment by the economy as a whole. The Chaebol in Korea and Enterprises owned

by Soharto's family in Indonesia are good examples to the case of moral hazard in the

Asian region due to the special prejudice made to such firms by governments in order

to keep their high profitability over almost a decade.

11

Krugman (1999), also, argued that this excessive risky lending by unregulated

financial institutions, particularly in property, had led to a sharp rise in assets prices,

which created a "Bubble" that eventually burst, precipitating the crisis. "The problem

began with financial intermediaries - institutions whose liabilities were perceived as

having an implicit government guarantee, but were essentially unregulated and

therefore subject to severe moral hazard problems. The excessive risky lending of

these institutions created inflation - not of goods but of assets prices. And then the

bubble burst"8. Indeed the Asian five had experienced "a boom-bust cycle" in asset

prices. Krugman (1999) has developed another model in order to explain how the

willing of unregulated financial intermediaries to bid on assets drove up the prices of

assets in the Asian region, based not on their expected returns but on the Pangloss

value. The model assumed that the rent on a unit of land could be either of 25 with

probability of 2/3 or 100 with a probability of 1/3. This means that the expected

return on this piece of land equals 50 (2/3*25+1/3*100). However, an owner of

financial intermediary, induced by moral hazard, would be willing to pay 100

(Pangloss value) to acquire the land. Thus, all land will end up priced with double its

real value and owned by financial intermediaries creating what is referred to as price

bubbles. On the other hand, Radelet and Sachs (1999) argued that perhaps it is more

correct to assume that creditors at that time financed these projects as they were

expecting them to maintain their high profitability and hence the ability to repay their

loans rather than expecting a crisis and a subsequent bailout. Also, some economists

were skeptical to accept the corruption, which indeed existed in the Asian countries

as Soharto's family in Indonesia, to be one of the main reasons of the crisis. They

simply argued that corruption had existed even before the crisis and perhaps for

decades, although this did not stop the Asian economies to grow very rapidly. "If

anything, corruption in Korea was probably worse in the mid-1980s than the mid-

1990s, and yet it did not face a similar crisis at that time"9. Finally, they concluded

8 "What Happened To Asia?” Krugman P. (1998) 9 "What Have We Learned, So Far, From the Asian Financial Crisis?" Radelet, S and Sachs, J. (1999).

12

that crony capitalism, indeed, was one of the factors that set the stage for the crisis

but it was not the main cause of a crisis with such magnitude and harshness. Perhaps

this becomes more evident if we review Krugman’s (1999) recent analysis, which

included an opposite argument to his former one in explaining the causes of the crisis.

Actually, Krugman’s recent argument put the financial panic, the over-liberalized

international and domestic financial systems, and the lack of banking supervision in

the heart of the crisis.

Nixson and Walters (1999) argued that Moral Hazard provided a mechanism to bond

the characteristics of the Asian crisis to the first- and second-generation currency

crisis models (models developed by Krugman 1979; Flood and Garber 1984; Obstfeld

1995) used to explain financial turmoil in emerging countries. In his explanation of

the first-generation crisis model, Krugman (1999) mentioned that a government with

persistent budget deficit financed by money creation was assumed to use its limited

stock of reserves to maintain a pegged exchange rate. This policy would be,

eventually, unsustainable due to inflationary pressures and depletion of reserves,

leading to loss of investors' confidence and generating a speculative attack on the

currency, especially when the reserves fell to some crucial point. While, the second-

generation models assume that governments have the choice to maintain a policy of

pegged exchange rates or not, taking into consideration the effect of the monetary

policy on economic growth. Indeed, from the first sight it is obvious that these

models cannot provide an explanation of the initial Asian currency crisis. Nixson and

Walters (1999) contended, "The Asian economies were in rough fiscal balance, credit

creation was not excessive and inflation was generally under control". However, as

argued by Nixson and Walters (1999) Moral Hazard, provided the tool to link the

Asian crisis to these models. Moral Hazard had induced foreign investors to lend

domestic financial institutions on the basis of implicit governmental guarantees. This

had encouraged excessively risky investments in low productive projects leading to

increased levels of inflation. Also, it implied an increase in governmental debts in the

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future if these guarantees need to be realized. Therefore, a deterioration of the

governments' future fiscal position can be anticipated.

However, it was recently contended (Radelet and Sachs 1998, Krugman 1999, and

Nixson and Walters 1999) that these arguments based on fundamental weaknesses,

structural problems and Moral hazard did not provide a sufficient explanation for the

causes of the crisis. They cited four main reasons for their argument listed as follows.

First, they stated that it is difficult to identify the crisis countries as experiencing

fundamental macroeconomic disequilibria. Second, the harshness of the fall in the

exchange rates was extremely more than enough to eliminate the deficits in the

current accounts. Third, the size of the bubble sectors was relatively small. Finally,

the contagion of the crisis from the countries of Southeast Asia to Korea in the North,

even though Korea had enjoyed a long period of strong real economy and the relative

lack of integration with other afflicted countries. Therefore, another explanations

were emerged in recent years trying to solve the paradoxes existed in the earlier

explanations such as the financial panic argument.

Financial Panic

It has been argued recently, among others, by Radelet and Sachs (1998) that

the main cause of the Asian crisis was the panicky outflows of capital rather than

fundamental macroeconomic weaknesses. In fact Sachs stated, "There is no

fundamental reason for Asia's financial calamity except financial panic itself. Asia's

need for significant financial sector reform is real, but not a sufficient cause for the

panic, and not a justification for harsh macroeconomic policy adjustments, Asia's

fundamentals are adequate to forestall an economic contraction: budgets are in

balance or surplus, inflation is low, private saving rates are high, economies are

poised for export growth. Asia is not reeling from a crisis of fundamentals but a self-

fulfilling withdrawal of short-term loans, one is that fuelled by each investor's

14

recognition that all other investors are withdrawing their claims. Since short-term

debts exceed foreign exchange reserves, it is rational for each investor to join in the

panic."10.

Financial panic as defined by Dybvig-Diamond (1983), in their model of a bank run,

is a case of multiple equilibria in the financial markets. Also, defined by Radelet and

Sachs (1998) as an adverse equilibrium result in which sudden withdrawals of short-

term loans from a solvent borrower occurs, In fact, Radelet and Sachs (1998) cited

two main reasons for financial panic: short-term liabilities exceed short-term assets

and the absence of lender-of-last-resort. The best example for the success of lender-

of-last-resort operations to overcome a crisis is, perhaps, the Mexican case. In early

1995 after the devaluation of the Mexican peso, the government could not rollover its

short-term debts. Therefore, the IMF and the United States, to provide Mexico with

about $50 billion to repay their debts, established a lender-of-last-resort jointly. In

fact, this action helped the Mexican government to prevent default and to restore its

economic growth in the subsequent year. However, it was argued that if the crisis is a

result of a bubble burst or a moral hazard end, then it is more appropriate to avoid the

lender-of-last-resort, as it will maintain the unproductive investments alive.

Therefore, it was concluded that the existence of the lender-of-last-resort is essential

only if the panic induced investors to suddenly withdraw their credit lines when it is

not necessary to do so.

Radelet and Sachs (1998) contended that the only reason that economists did not

attribute the causes of the Asian crisis to panic simply because economists always

pursue more sophisticated explanations for financial crises. "Financial panic is rarely

the favored interpretation of a financial crisis. The essence of a panic is that a 'bad'

10 Sachs, quoted in Nixson and Walters, 1999, pp. 507

15

equilibrium occurs that did not have to happen. Market analysts and participants are

much more prone to look for weightier explanations than simply a bad accident"11.

As a matter of fact, the advocates of the financial panic argument did not deny the

existence of some fundamental and structural problems in the Asian economies. But it

is also true that they did not accept these problems as the main causes of the crisis.

Radelet and Sachs (1998) reconstructed the crisis in the context of the following

scenario, to make it evident that the Asian crisis was triggered by financial panic,

disorderly workout and policy mistakes. The scenario started with panicky

withdrawal of short-term capital from the Asian region. As a consequence the

maturity mismatch of the banking sector had been exposed resulting in liquidity

problems and a surge in interest rates. Thus, even previously profitable and

productive firms found it very hard to both obtain working capital and survive these

high interest rates. Furthermore, offshore creditors, to protect their clients' money,

declined to rollover short-term loans. In this panicky environment banks found it very

difficult to keep their minimum capital adequacy standards. Also, panicky domestic

depositors exacerbated the liquidity problem by claiming their funds from banks,

putting the whole banking sector under further pressures. Additionally, it was

contended that the policy mistakes committed by the Asian governments at that time

contributed to the crisis precipitation. "Had Thailand responded to the fall in property

prices in early 1997 by floating the baht and moderately tightening monetary and

fiscal policies, the Asian financial crisis could have been largely avoided. Thailand

and Korea, of course, made the paramount mistake of trying to defend their exchange

rate peg until they had effectively exhausted a substantial proportion of their foreign

reserves"12.

11 The Onset of the East Asian Financial Crisis, Steven Radelet and Jeffrey Sachs (1998). 12 The Onset of the East Asian Financial Crisis, Steven Radelet and Jeffrey Sachs (1998).

16

In fact Radelet and Sachs (1998) have given two main reasons for the dominance of

the financial panic argument. First, the crisis hit countries with the highest ratios of

short-term foreign debts relative to short-term assets. Second, the severity of the crisis

was highly decreased one year later, although many of the fundamental weaknesses

were not substantially eliminated.

Political Instability and Policy Mistakes

One of the main causes of the crisis as contended by most of the economists,

was the political instability of the Asian countries at the time of the crisis. In fact,

political instability may affect the level of cash inflows, to a certain country, from the

international financial community. Corsetti et al (1998 b) contended that the

deterioration in expectations about the political environment in any country can have

negative effects on this country's balance of payment, exchange rate and eventually

may contribute to larger budget deficits.

In this context, if we visit the Asian five during the days of the crisis, we will find

that there were some tensions accompanying the elections in Indonesia besides the

uncertainty of the news about the health status of Soharto at that time. In Malaysia,

Mahathir claims against "rouge speculators", the government collapse in Thailand

and the presidential election in Korea contributed, indeed, to the precipitation of the

capital flight and eventually the full-fledged crisis.

In addition, although the Asian governments did sign agreements with the IMF, they

did not take the implementation of this early-stage IMF measures seriously,

regardless whether or not they were suitable for the Asian case. This added more

clouds on the uncertainty surrounded the governments’ intentions to conquer the

crisis. "Regardless of whether the initial IMF plans were appropriate, it is clear that

governments failed to enforce even the most sensible components of such plans. In

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Indonesia, a corrupt and authoritarian regime effectively ignored most of its agreed-

upon commitments until the severe deterioration of macro conditions led to a fully

fledged collapse and the free fall of the rupiah. For the case of Korea, there were

serious doubts about the implementation of the first IMF plan, given the coming

elections in December and the broad policy uncertainty associated with the event. In

Thailand, it was only with a new government truly committed to economic reforms

that the value of the baht stabilized, and even appreciated relative to the lows

reached in December"13.

The IMF Role

At the onset of the crisis the Asian governments, except the Malaysian, found

it essential to get the assistance of the IMF in order to overcome the 'bad days'. In

fact, many commentators criticized the IMF intervention to the extent that it was

argued that the IMF exacerbated the deepness of the crisis. It was also argued that the

IMF measures increased the financial panic at the midst of the crisis.

On the other hand the IMF's managing director. Michel Camdessus advocated the

Fund's intervention as follows, "As soon as it was called upon, the IMF moved

quickly to help Thailand, then Indonesia, and then Korea formulate reform programs

aimed at tackling the roots of their problems and restoring investor confidence. In

view of the nature of the crisis, these programs had to go far beyond addressing the

major fiscal, monetary, or external balances. Their aim is to strengthen financial

systems, improve governance and transparency, restore economic competitiveness,

and modernize the legal and regulatory environment”14. Before further reviewing

13 "What Caused The Asian Curreny and Financial Crisis? Part I: A Macroeconomic Overview" Corsetti, G. Pesent, P. and Roubini, N. (1998).

14 "What Caused The Asian Curreny and Financial Crisis? Part II: A Policy Debate" Corsetti, G. Pesent, P. and Roubini, N. (1998).

18

either the critiques or the advocates of the IMF intervention, it is useful to summarize

the Fund's programs in the coming few lines.

In response to the precipitation of the crisis the IMF approved large standby credits

for the afflicted countries. However, it was contended by Radelet and Sachs (1998)

that the actual credit granted for such countries was far smaller. The IMF had

approved $17.2 billions, $40 billions and $57 billions packages for Thailand,

Indonesia and Korea respectively. In fact, these rescue-packages were conditional

upon the acceptance of some measures formulated by the Fund. These measures

included, principally, fiscal contraction policy, bank closures, tight monetary policy

and the imposition of structural reform programs for both the financial and

commercial systems. The fiscal contraction aimed at helping the governments to

maintain a tight monetary policy, and thus, protecting the currencies against further

depreciation. Bank closures and the enforcement of capital adequacy standards aimed

at limiting the losses carried by unviable banks as well as signaling the seriousness of

the governments to carry on the reform programs. Additionally, the reforms programs

mainly for the commercial framework aimed at setting the stage for a better business

environment.

It was argued that these measures reflected the IMF's diagnosis of the crisis, which

apparently, assumed that the existence of fundamental weaknesses and structural

problems in the Asian economies is the main cause of the crisis. Also, Nixson and

Walters (1999) pointed out that the IMF's goals of raising the interest rates, restoring

current account equilibrium, and starting a structural reforms of the financial and

commercial systems would reflect sufficient signals of the Asian governments' 'bona

fides' to restore confidence and capital inflows. In fact these early-stage programs

failed to achieve the goals and, additionally, none of them ended in its original form

for more than few weeks. Therefore, new agreements were signed with Thailand,

Korea and Indonesia. Furthermore, Nixson and Walters (1999) pointed out that it is

19

clear that the IMF's initial measures failed to meet its objectives of stabilizing

exchange rates and restoring capital inflows.

In fact economists cited so many reasons for the IMF's unsuccessfulness. Radelet and

Sachs (1998) stated, " But there are several reasons to believe that the underlying

design of programs added to, rather than ameliorated, the panic". It was argued that

there are three main reasons can be attributed to the fail of these initial programs.

First, the bank closures decision was heavily criticized by some economists as it,

arguably, added to the financial panic and induced a case of bank-run at the midst of

the crisis. Sachs (1998) stated, "In my view, although it's a minority opinion, the IMF

did a lot of confidence-reducing measures. In particular, I blame the IMF for

abruptly closing financial institutions throughout Asia, sending a remarkably abrupt,

unprepared and dangerous signal /...../ that you had better take your money out or

you might lose it"15. In addition Radelet and Sachs (1998) argued that it was much

better to implement a more comprehensive strategies for bank restructuring over a

longer time horizon, instead of this "quick show of force designed simply to

demonstrate resolve". And they cited the massive Indonesian bank's run as evidence

supporting their argument.

On the other hand Corsetti et al (1998 b) pointed out that other economists advocated

the implementation of this measure, as some banks were in "bad shape", and

supported their views by the fact that the banks closures program was imposed in

Indonesia along with Thailand and Korea, however, neither country experienced

banks runs of the same magnitude as those hit Indonesia.

Second, many analysts had questioned the appropriateness of the tight monetary

policy imposed in the crises countries. In fact it was argued that raising interest rates

during a financial crisis would cause a further deterioration in the exchange rate

15 Jeffrey Sachs, an interview in Asia week, Feb. 1998 quoted in Corsetti et al (1998 b)

20

rather than improving it. "Tight money in a given financial center can serve either to

attract funds or repel them, depending on expectations that a rise in interest rates

generates. With inelastic expectations -- no fear of crisis or currency depreciation--

an increase in the discount rate attracts funds from abroad, and helps to provide the

cash needed to ensure liquidity; with elastic expectations of change-- of falling

prices, bankruptcies, or exchange depreciation-- raising the discount rate may

suggest to foreigners the need to take more funds out rather than bring new funds

in16". As a matter of fact, high interest rates in the Asian crisis did not help to

maintain the Asian currencies' values, on contrary, exchange rates continued to

plunge after the signing of the IMF programs. Supporting this argument, Corsetti et al

(1998 b) contended that the appropriate policy response to the crisis should have been

one of loose money and low interest rates. On the other hand, it was argued that a

policy of loose money would induce further currency depreciation, and hence, raising

the value of banks' foreign currency denominated obligations. Finally, Corsetti et al

(1998 b) concluded, "While the appropriate interest rate policy at the onset of the

crisis is still subject to a wide spread debate, at the time of this writing -- and in the

light of the large recessions experienced by the Asian economies in 1998 -- most

observers sum to agree that high interest rates maintained beyond an emergency

scenario can have destabilizing consequences".

In the recognition of its advantages and disadvantages, many analysts questioned

whether the tight monetary policy's benefits had outweighed its costs in the Asian

economies during the crisis. The IMF announced early that they are self confident

that the benefits will be far higher than the costs. Subsequently, Furman and Stiglitz

(1998) expressed their concerns that the high interest rates had worsened the crisis

rather than easing it up. They proved that not only the high interest rates didn't help to

maintain the exchange rates but also local banks and business entities had paid a very

expensive price for the policy. In the mean time Radelet and Sachs (1999)

16 Kindleberger (1978) quoted in Radelet and Sachs (1998).

21

summarized the debate in the following words' "Finally, while sustained high interest

rates may have contributed to the eventual strengthening of these currencies, that by

itself does not justify the policy, since the costs to banks and firms were very high,

and the interest rate policy may have helped to trigger the panic in the first place.".

Third, it was argued that the deflationary fiscal program imposed in the crises

countries was unnecessarily and harmfully strict. "The fund initially demanded a

fiscal surplus of 1 per cent of GDP in each country. It is not clear why government

budgets were made so central to the programs, since fiscal policy had been fairly

prudent across the region,, and budget profligacy was clearly not the source of the

crisis" Radelet and Sachs (1998). On the other hand Corsetti et al (1998 b) pointed

out that some commentators argued that loose fiscal policy at the onset of the crisis

would have been a matter of concern among investors that policy makers are not

sufficiently committed to reduce current account imbalances.

Finally Nixson and Walters (1999) noted that this severe criticism of the IMF's role in

handling the Asian crisis stemmed mainly from the emergence of alternative

diagnoses of the central problem triggered the crisis. These alternative diagnoses

included the instability of international capital markets and financial panic as the

central contributory factors in the crisis. Therefore, the advocates of these diagnoses

proposed another measures in response to the Asian crisis.

Malaysian Help yourself Policy

In the year of 1998 the financial crisis that hit Malaysia, along with other

countries in the Southeast Asia region was intensifying. Many countries of the region

knocked the IMF doors to conquer the crisis such as Thailand and South Korea.

Dissimilarly, Malaysia’s Prime Minister Mahathir in September 1st 1999, decided to

adopt a “help your self” strategy, which aimed at ending the speculation against the

Malaysian currency “Ringgit”. Accordingly, the Malaysian government imposed

22

controls on capital outflows, and fixed the exchange rate at MR 3.8/1 Dollar along

with maintaining an autonomous monetary policy, which allowed them to cut interest

rates without affecting the exchange rate.

It was argued by Sebastian Edwards (1999)17 that one of core problems that triggered

the 1990’s financial crisis the free mobility of capital to and from countries hit by the

crisis. Also, it was argued that it is not possible for any country to maintain free

capital flows and policy of fixed exchange rate without using its monetary policy just

for this reason. Perhaps this become more obvious, if we use McKinnon and Oates

words “no government can maintain fixed-exchange rates, free capital mobility, and

have an independent monetary policy, one of the three options must give”.

Furthermore, this is referred to, as argued by Obstfeld and Taylor 1998, as

“incompatible trinity or the trilemma”18.

From above we can appreciate the merits of using capital controls in helping

governments in implementing both fixed exchange rates and independent monetary

policies, similarly to what happened in Malaysia. In fact maintaining fixed-exchange

rates, and autonomous monetary policy are not the goals by themselves, however,

they help governments to achieve their real objective of overcoming financial crisis,

without increasing the unemployment rates or slowing down the economy.

Furthermore, they help governments to prevent the occurrence of “balance of

payment crisis” through correcting any balance of payments deficit. “Thus, capital

controls are sometimes described in terms of the choices they avoid: to prevent

capital outflows that, through their effect on the balance of payments, might either

endanger fixed-exchange rates or independence of monetary policy”19

However, there are some drawbacks of limiting free capital mobility among

countries. The most important drawback as contended by Christopher J. Neely is

limiting the benefits of capital flows, which are represented in facilitating,

consumption patterns; technology transfer; and portfolio diversification. Another

drawback is the possibility of evading capital controls either on inflows or outflows,

simply by over or under pricing invoices. Furthermore, controls can be avoided either

17 The mirage of capital controls, Sebastian Edwards, May 1999. 18 An introduction to capital controls. Christopher J. Neely 19 An introduction to capital controls. Christopher J. Neely

23

by delaying or speeding up payments to foreign suppliers – known as “leads and

lags” 20. Avoidance of such controls will consequently impair the effectiveness and

deteriorate the system. If government turns a blind eye to this evading, the existence

of controls will lead to a “false sense of security”21. In addition, imposing capital

controls might lead to lack of confidence of investors in the domestic economy.

Did Capital Controls work?

In fact the answer to this question is quite controversial. On one extreme some

economists supported the notion of the inefficiency of capital controls and argued that

they may harm the successfulness of a country’s economy, “The consensus among

economists has been that capital controls—like tariffs on goods—are obviously

detrimental to economic efficiency because they prevent productive resources from

being used where they are most needed.”22. Moreover they contended that capital

controls did not help in recovering from the 1980’s debt crisis, “Those Latin

American countries that stepped-up controls on capital outflows – Argentina, Brazil

and Mexico, to mention just the largest ones– muddled through, and experienced a

long and painful decline in growth, high inflation and rampant unemployment”23.

At the other extreme, others highly supported the use of capital controls, in addition

they argued that capital controls could be considered to be efficient tools to overcome

financial crisis, similarly to what happened in Malaysia in 1998. “Malaysia recovered

from the Asian financial crisis swiftly after the imposition of capital controls in

September 1998. Compared to IMF programs, we find that the Malaysian policies

produced faster economic recovery, smaller declines in employment and real wages,

and more rapid turnaround in the stock market”24.

And in the middle of the road there is a group who contended that although capital

controls cannot be considered as successful tools to overcome the financial crisis,

they indeed give governments the sufficient time to undertake reform procedures in

order to overcome their problems. “Even economists who oppose capital controls

20 Einzing, Paul. Leads and Lags, MacMillan and company, 1968. 21 The mirage of capital controls, Sebastian Edwards, May 1999. 22 An introduction to capital controls. Christopher J. Neely 23 The mirage of capital controls, Sebastian Edwards, May 1999. 24 Did the Malaysian capital controls work?, Ethan Kaplan and Dani Rodrik.

24

believe that they may have been of some use in buying time to implement fundamental

reforms”25.

In fact, the Malaysian business community at that time was happy with the economic

stability resulted from adopting such policies. But on the other hand the middle-of-

the-road group who claimed that “buying time for reform” is the only benefit of

imposing capital controls, was concerned that government did not undertake real

economic-reform procedures, the case which may ultimately worsen the situation

rather than improving it. “Others fear, however, that the capital controls have

replaced reform, rather than buying time for reform. As of May 1999, the Malaysian

government does not appear to be using the breathing space purchased by the capital

controls to make fundamental adjustments to its fragile and highly leveraged

financial sector. Rather, Prime Minister Mahathir has sacked policymakers who

advocate reform while aggressively lowering interest rates, loosening nonperforming

loan classification regulation and setting minimum lending targets for banks”26.

Kaplan and Rodrick asked, “Did the Malaysian gamble pay off”, I think that the

answer to this question is, obviously “Yes” they managed to recover from the

financial crisis. However, I think that this leads to a more important question of “Did

this recovery was a direct result of imposing capital controls”. The answer to this

question is quite simple: “Yes”, but we should take into consideration that the main

reason for imposing such controls was to cut the speculation against the Malaysian

ringgit at that time. In other words, I think that Malaysian experience suggests that

capital controls worked efficiently to cut the speculation against its currency,

however, they would not have worked effectively if the Malaysian crisis was more

severe, like in other countries.

Conclusion

The Asian financial crisis, apparently, had increased economists' demand for

the development of new international financial architecture. One that would help to

25 An introduction to capital controls. Christopher J. Neely 26 An introduction to capital controls, Christopher J. Neely.

25

minimize the possibility of a new crisis with such magnitude and effect and even if it

occurs the new architecture should help to overcome the crisis in a more elegant

manner than happened in the Asian crisis. The Asian crisis induced many analysts to

cast some doubts about the suitability of rapidly liberalizing emerging markets. It was

argued that the rapid financial liberalization of the Asian economies in the early

1990s did not enable policy makers to put sufficient regulatory and supervision

systems in place, and therefore, made them more crisis prone than other emerging

markets with slower liberalizing steps. In fact, the lack of a robust regulatory system

led to a massive short-term lending from abroad by domestic banks without taking

into consideration the high vulnerability of such short-term capital inflows to large

reversals, the case that exposed the whole region during the crisis. Radelet and Sachs

(1999) argued that short-term cross-border debt flows should be the last item on the

liberalization list, since they are highly vulnerable to volatility and Panic. Similarly

Fischer (1999) argued that although there is no need to have controls on longer term

capital inflows, it is preferable for emerging markets to have market-based controls

on short-term capital. Actually, both authors had cast the Chilean and Malaysian

cases as evidence supporting their arguments. "Many analysts attribute Chile's ability

to avoid financial crises in the wake of the panics in Mexico, Argentina and Asia to

these restrictions and Chile's small stock of short-term foreign debt"27. However,

Fischer returned to argue that these controls either on capital inflows or outflows

should be for a short time period "While it may be tempting to impose capital outflow

controls to deal with short-term crisis, as Malaysia did in 1998, the longer-term

consequences are likely to be adverse"28. In addition, it was recommended that

emerging markets should start to build strong domestic banking and financial

systems. Furthermore Fischer (1999) argued that it is not only regulations and

supervision that are needed to modernize banking sector in emerging markets, but

also competition, particularly, foreign competition is an essential element.

27 What Have we Learned So Far from The Asian Financial Crisis? Steven Radelet and Jeffery Sachs (1999). 28 Reforming the International Financial System. Stanley Fischer (1999).

26

Another fact has been unearthed from the unfolded crisis that the fixed exchange rate

policy is very dangerous to adopt as it may lead to complete depletion of the reserves

and eventually a huge depreciation. Indeed fixed exchange rates had been advocated,

for decades, for being able to reduce volatility of currencies. However, the facts from

the Asian crisis made it clear that they are more vulnerable to extensive devaluations

when they cannot be protected anymore. Accordingly, many economists

recommended the use of more flexible exchange rates by emerging markets in the

new financial architecture.

Moreover, it was argued that the Asian crisis had shown the importance of

establishing efficient systems in emerging markets to provide complete and fully

transparent information. This information should cover the government's activities,

country's policies, the state of the economy as well as covering private firms

activities. Also, the need of clear and strong corporate finance and governance

including efficient bankruptcy laws was made clear by many economists in the wake

of the crisis.

Finally many arguments have been made to emphasize the role of International

Financial Institutions in helping countries to effectively implement reform programs

to improve both their economies and the quality of international capital flows. In fact,

Fischer (1999) has briefly listed the elements of a new financial architecture, in the

wake of the Asian crisis, as follows:

"In particular work is on going (i) to strengthen financial systems and economic

policies by encouraging the design and adoption of banking and other relevant

standards; (ii) to encourage the provision of better information to the markets and to

the public more generally; (iii) to improve surveillance of economic and financial

developments and policies: and (iv) to consider changes in IFI (International

Financial Institutions) lending practices".

27

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29