What was the Asian Financial Crisis?
Asian Financial Crisis Causes, Resolution, and Lessons
"Popular enthusiasm about Asia's boom deserves to have some cold water thrown on it." - Paul Krugman, The Myth of Asia's Miracle, 1994
The Asian Financial Crisis of 1997 was a financial crisis that affected many Asian countries, including South Korea, Thailand, Malaysia, Indonesia, Singapore and the Philippines. After posting some of the most impressive growth rates in the world at the time, the so-called "tiger economies" saw their stock markets and currencies lost about 70% of their value.
In this article, we will take a look at the causes of the Asian financial crisis and the solutions that ultimately brought about a recovery, as well as some lessons for modern times.
Causes of the Asian Financial Crisis
The Asian Financial Crisis, like many other financial crises before and after it, began with a series of asset bubbles. Growth in the region's export economies led to high levels of foreign direct investment, which in turn led to soaring real estate values, bolder corporate spending, and even large public infrastructure projects - all funded largely by heavy borrowing from banks.
Of course, ready investors and easy lending often lead to reduced investment quality and excess capacity soon began to show in these economies. The United States Federal Reserve also began to raise its interest rates around this time to counteract inflation, which led to less attractive exports (for those with currencies pegged to the dollar) and less foreign investment.
The tipping point was the realization by Thailand's investors that its property market was unsustainable, which was confirmed by Somprasong Land's default and Finance One's bankruptcy in early 1997. After that, currency traders began attacking the Thai baht's peg to the U.S. dollar, which proved successful and the currency was eventually floated and devalued.
Following this devaluation, other Asian currencies including the Malaysian ringgit, Indonesian rupiah and Singapore dollar all moved sharply lower. These devaluations led to high inflation and a host of problems that spread as wide as South Korea and Japan.
Solutions to the Asian Financial Crisis
The Asian Financial Crisis was ultimately solved by the International Monetary Fund (IMF), which provided the loans necessary to stabilize the troubled Asian economies. In late 1997, the organization had committed over $110 billion in short-term loans to Thailand, Indonesia and South Korea to help stabilize the economies - more than double its largest loan earlier.
In exchange for the funding, the IMF required the countries to adhere to strict conditions, including higher taxes, reduced public spending, privatization of state-owned businesses and higher interest rates designed to cool the overheated economies. Some other restrictions required countries to close illiquid financial institutions without concern for employment.
By 1999, many of the countries affected by the Asian Financial Crisis showed signs of recovery with gross domestic product (GDP) growth resuming. Many of the countries saw their stock markets and currency valuations dramatically reduced from pre-1997 levels, but the solutions imposed set the stage for the reemergence of Asia as a strong investment destination.
Lessons of the Asian Financial Crisis
The Asian Financial Crisis has many important lessons that are applicable to events happening today and events likely to occur in the future.
Here are some important takeaways:
- Watch Government Spending - Government dictated spending on public infrastructure projects and guidance of private capital into certain industries contributed to asset bubbles that may have been responsible for the crisis.
- Re-Evaluate Fixed Exchange Rates - Fixed exchange rates have largely disappeared, except for instance where they use a basket of currencies, since flexibility may be needed in many cases in order to avert crisis like these.
- Concerns about the IMF - The IMF took a lot of criticism after the crisis for being too strict in its loan agreements, particularly with successful economies like South Korea. Moreover, the moral hazard created by the IMF may be a cause of the crisis.
- Always Beware of Asset Bubbles - Investors should carefully watch out for asset bubbles in the latest/hottest economies around the world. All too often, these bubbles end up popping and investors are caught off-guard.
The Bottom Line
The Asian financial crisis began with a series of asset bubbles that were financed with foreign direct investment. When the Federal Reserve began to hike interest rates, foreign investment dried up and high asset valuations were difficult to sustain. Equity markets moved significantly lower and the International Monetary Fund eventually stepped in with billions of dollars worth of loans to stabilize the market. The economies eventually recovered, but many experts have been critical of the IMF for its strict policies that may have exacerbated the problems.