Why the Asian Financial Crisis Happened
By Paul Brothwood
In 2004, I wrote my dissertation about the Asian financial crisis through a simple question: had the crisis exposed a failure of free markets, or had governments created the conditions for failure through poor policy and weak implementation? My answer then leaned heavily towards the second explanation. Rereading the evidence now, I think that answer caught part of the truth, but it placed too little weight on the behaviour of private lenders and the speed at which international confidence collapsed.
The short answer is that several risks
built up at the same time. Large amounts of foreign money entered fast-growing
Asian economies. Banks and companies borrowed heavily in US dollars, often for
short periods, then invested the money in longer-term domestic projects.
Financial supervision failed to keep pace. Managed exchange rates made foreign
borrowing appear safer than it was. When lenders changed their view of the
risk, capital left quickly. Currency falls then made dollar debts far harder to
repay.
No single cause explains the crisis. Nor should Thailand, Indonesia, Malaysia, the Philippines and South Korea be treated as if they had identical economies. Their institutions and policy choices differed. What linked them was a shared exposure to a sudden loss of international liquidity.
The trigger came in Thailand
The immediate trigger came on 2 July 1997,
when Thailand abandoned its defence of the baht and allowed the currency to
float. Pressure had been building for months. Thailand had received major
capital inflows, much of the money had moved into property and other weak
investments, and the country was running a large current-account deficit. The
central bank used foreign exchange reserves to defend the currency, but that
defence could not continue indefinitely.
Once the baht fell, investors began to
reassess other economies that appeared to share some of Thailand's weaknesses.
Pressure moved to the Philippine peso, Malaysian ringgit and Indonesian rupiah.
South Korea entered severe difficulty later in 1997. A national problem had
become a regional crisis.
The fall of the baht was the match, not the
fuel. The fuel had accumulated during the preceding boom.
Success encouraged too much confidence
The affected economies had spent years
attracting praise for high growth, rising exports and industrial development.
That success encouraged investors to treat the region as a low-risk
destination. Foreign funds were available at relatively low interest rates, and
local borrowers often paid more than lenders earned at home. The result was a
powerful incentive to move money into Asia.
Capital inflows were not harmful by
themselves. Productive investment funded roads, factories, technology and
business growth. The danger lay in the amount, maturity and use of the
borrowing. In several countries, credit expanded faster than the institutions
responsible for assessing and supervising it. Property prices rose, corporate
borrowing increased and lenders accepted projects with weak returns.
My dissertation drew heavily on the
explanation offered by Giancarlo Corsetti, Paolo Pesenti and Nouriel Roubini.
They identified exchange-rate problems, competitive devaluations, excessive
investment, moral hazard in banking and large capital inflows. Those factors
still provide a useful account of the build-up. The weakness is that they sound
separate on paper. In practice, each one reinforced the others.
Currency pegs disguised the risk
Many governments kept their currencies
fixed or closely managed against the US dollar. This helped trade and gave
investors a sense of stability. It also encouraged banks and companies to
borrow in dollars without protecting themselves against exchange-rate changes.
If the local currency stayed close to the dollar, the risk appeared small.
The arrangement became harder to sustain as
the dollar strengthened against the Japanese yen. Export competitiveness
weakened in parts of the region. Current-account pressures grew. Investors
started to question whether the official exchange rates reflected economic
reality.
A Thai government finance official who
responded to my research in 2004 made this point directly. Thailand was trying
to maintain a pegged exchange rate at the same time as it opened its financial
system. In his view, those policies did not fit together. A more open financial
market required greater exchange-rate flexibility.
Short-term foreign debt was the fault line
The structure of the debt mattered as much
as its total size. Banks and companies had borrowed foreign currency for short
periods, then lent or invested it for longer periods. They relied on overseas
lenders renewing those loans. This created a maturity mismatch. Money was due
before the assets it funded produced enough cash to repay it.
It also created a currency mismatch.
Borrowers earned baht, rupiah or won but owed dollars. When local currencies
fell, the value of those debts rose sharply in domestic terms. A company that
had looked solvent before devaluation could become unable to meet its
obligations without changing anything else about its business.
Later work by the Bank for International
Settlements showed how exposed several countries had become. Before the crisis,
short-term foreign debt was rising faster than foreign exchange reserves. In
Indonesia, South Korea and the Philippines, reserves eventually covered less
than half of overall short-term foreign debt. That left national authorities
with too little liquid foreign currency when creditors demanded repayment.
Weak supervision allowed poor lending
Financial opening moved faster than
supervision. Banks expanded lending without the systems, capital or
transparency needed to control the risk. In some countries, close links between
governments, banks and large companies distorted lending decisions. Credit did
not always flow to the strongest commercial projects.
Government guarantees, formal or assumed,
added moral hazard. Lenders and borrowers behaved as if important institutions
would be rescued. In South Korea, the large family-controlled chaebols could
borrow heavily through banks and other financial institutions. Their scale and
political importance encouraged the belief that failure would not be allowed.
Article five in this series will look at that relationship in detail.
The problem was not government involvement
alone. Private banks and international creditors also mispriced risk. They were
willing to lend into the boom, then unwilling to renew loans when sentiment
changed. Each lender had a reason to protect itself. Their collective
withdrawal deepened the crisis.
Confidence turned weakness into collapse
Economic weaknesses made the countries
vulnerable, but they do not fully explain the speed or scale of the collapse.
Confidence changed faster than factories, skills or productive capacity. Once
investors suspected that a currency would fall or that reserves were
inadequate, withdrawing money looked rational. The withdrawals then made the
feared outcome more likely.
This is where market herding mattered.
Investors watched each other as well as the facts. A fall in one country became
evidence against another. Countries with different conditions were grouped
together. Governments raised interest rates or spent reserves to defend their
currencies, but those actions carried economic costs and often failed to
restore trust.
When currencies did fall, the burden of
foreign-currency debt increased. Banks weakened, companies failed and credit
contracted. What began as a currency problem became a banking and corporate
crisis, then a wider social crisis involving job losses, lower wages and
poverty.
What my 2004 argument missed
My dissertation accepted what was often
called the fundamentals explanation. It placed weight on fixed exchange rates,
poor investment, weak banking supervision, moral hazard and policy mistakes. I
still think those points were well founded. A financial system opened to
international capital without strong oversight carries obvious risks.
Where I was too certain was in treating
private capital flight mainly as a rational response to flawed domestic policy.
That understates the part played by lenders during the boom and the panic.
Foreign creditors helped create the exposure by supplying large amounts of
short-term money. When many tried to leave together, they turned vulnerability
into collapse.
The better explanation joins the two
accounts. Domestic weaknesses made the region exposed. International finance
supplied the volume and speed. Managed exchange rates hid currency risk. Short
maturities made borrowers dependent on constant refinancing. Weak supervision
allowed the money to be used badly. Herding and contagion then accelerated the
reversal.
So why did the Asian financial crisis happen?
It happened because financial
liberalisation moved faster than the institutions needed to manage it. It
happened because banks and companies borrowed short-term money in foreign
currencies and invested it in longer-term domestic assets. It happened because
stable exchange rates encouraged borrowers to underestimate currency risk. It
happened because political relationships and weak supervision damaged lending
discipline. It happened because international investors first underestimated
the danger and then reacted together when confidence broke.
The crisis was not proof that markets
always fail or that governments always know better. It was a failure in the
relationship between public policy, private finance and financial institutions.
Each relied on the others behaving in a way that the system did not guarantee.
That is the main change in my view since 2004. I would no longer search for one side to blame. The more useful question is why the safeguards failed at the same time. The answer lies in the way the boom was financed and in how quickly confidence disappeared once lenders realised that the apparent stability was fragile.
Asian Financial Crisis series
2. Why the Asian financial crisis happened. (This article).
3. State versus market after the Asian financial crisis.
4. The IMF's controversial response to the Asian financial crisis.
5. South Korea, chaebols and banking failure.
6. What the Asian financial crisis can still teach us.
About the author
Paul Brothwood is an operations manager,
Chartered Environmentalist and sustainability professional based in the West
Midlands. His career has included senior leadership in banking, construction,
public service and electricity distribution. He writes about leadership,
sustainability, motorcycles, travel and lessons from earlier academic work.
This article revisits the dissertation he completed in 2004 on the Asian
financial crisis.
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