The Asian Financial Crisis of 1997: Causes and Policy Responses

Abstract

For years, East-Asian countries were held up as economic Icons. Their typical blend of high savings and Investment rates, autocratic political systems, export-oriented businesses, restricted domestic markets, government capital allocation, and controlled financial systems were hailed as the Ideal recipe for strong economic growth of developing counties (Shapiro, 1999). However, in July 1997, a currency turmoil erupted In Thailand. This currency crisis spread from there to Indonesia and Korea, then to Russia, then to Latin America. Few countries have not been touched by the global forces that this crisis--some accounts the worst since the 1980s debt crisis--have unleashed. Professor Paul Krugman who threw cold water on the popular enthusiasm on the Asian success story even before the crisis said, I was 90 percent wrong about what was going to happen, but everyone else was 150 percent wrong. They only saw the miracle and one of the risk. RECENT INTERNATIONAL FINANCIAL CRISES The 1997 Asian crisis is the 4th international financial crisis. The first major blow to the international financial system took place in August 1982, when Mexico announced that it could not meet its regularly scheduled payments to international creditors. Shortly thereafter, Brazil and Argentina were in the same situation. By Spring 1983, about 25 developing countries could not make regularly scheduled payments and negotiated rescheduling with creditor banks. These countries accounted for two-thirds of the total debt owed by non-oil developing countries to private banks at the time. The second crisis occurred in the fall of 1992, when a wave of speculative attacks hit the European Monetary System (EMS). Before the end of the year, five countries--Finland, the United Kingdom, Italy, Sweden, and Norway had floated their currencies. Despite attempts by a number of other countries to remain in the EMS by devaluing their currencies (Spain, Portugal, and Ireland), the old system was ultimately unsalvageable. The bands of the EMS were widened from +/- 2.25 percent to +/- 115 percent in August 1993. The third crisis came on December 20,1994 when the Mexican government announced its decision to devalue the peso against the dollar by 14 percent. This decision, however, touched off a panic situation to sell pesos, thereby compelling the Mexican government to float the peso. A rash of speculative attacks against other Latin American currencies--Argentina (peso), Brazil (real), Peru (new sol), and Venezuela (bolivar)--broke out immediately through what became known as the tequila effect. Several non-Latin American countriesThailand, Hong Kong, the Philippines, and Hungarysuffered brief speculative attacks. However, only few countries actually devalued their currencies. Argentina was the only other country that suffered a sharp recession as a result of the Mexican peso crisis. The Asian crisis of 1997, despite prompt and concerted action by developing countries, industrialized countries, and international organizations to contain it, quickly and ferociously spread to north Asian, Latin, and eastern European economies to varying degrees. In fact, this Asian crisis had pushed one-third of the globe into recession during 1998. The crisis has raised a variety of questions not only about the future of the region's economy, but also about the impact of the crisis on multinational companies and the world economy. All four crisis episodes occurred under fixed exchange rate regimes. Economic theory suggests that a pegged exchange rate regime can become vulnerable when cross-border capital flows are highly mobile. A central bank that pegs its exchange rate to a hard currency implicitly guarantees that any investors can exchange their local currency assets for that hard currency at the prevailing exchange rate. If investors suspect that the government will not or cannot maintain the peg, they may flee the currency; this capital flight, in turn, delete hard currency reserves and force the devaluation they fear. …