The Asian Crisis : The Causes and Consequences of Financial Crises
Nigel F. B. Allington and John S. L. McCombie
Introduction
A number of countries of Asia have achieved unprecedently high rates of both output and income per
capita growth over the last three decades. The rates of growth have been the fastest sustained expansion
the world has ever seen. The most notable successes have been what have come to be known as the four
“Asian Tigers” (Hong Kong, South Korea, Singapore and Taiwan) and their growth has been seen as an
economic miracle. In the course of one generation they have come from being amongst the poorest
countries to economies with technologies rivalling the industrialised countries. Within a few years Hong
Kong and Singapore are predicted to overtake the US in terms of per capita income, having already left the
UK well behind.
Over the period, 1965-1995 the Tigers have averaged growth rates of output per person of over 6 per
cent, which, given that they are average growth rates, is truly remarkable. As Sarel (1997) points out, while
the average resident of a non-Asian country was nearly three-quarters better off in 1990 than his parents
were in 1960, the corresponding person in Korea was over 6 times better off. Or to put the same point
slightly differently, in 1965 Korea had a per capita income that was less than 10 per cent that of the US
(roughly comparable to Bangladesh’s position today). At that time Korea was considered to have less
development potential than a number of African countries. But by 1995, Korea’s per capita income had
increased to about half the US’s level.
Of course, on the one hand, it might be rightly objected that in spite of all the interest that Hong Kong
and Singapore have attracted they are not really significant in terms of economic size, having populations
of only 3 million. But, on the other hand, Korea is rapidly becoming an industrial giant; it is the eleventh
largest economy in the world and was recently admitted to the OECD. Taiwan is also a significant world
player in terms of the size of its economy.
The Southeast Asian economies (Indonesia, Malaysia, Thailand, and, more recently, the Philippines)
have also been growing rapidly on the coattails of the Tigers. Over the last thirty years their average per
capita growth rates have been about 4 per cent per annum, although by the early 1990s they were growing
as fast as the Tigers. The performance of this group of countries has been more varied with the Philippines
growing noticeably slower than the other countries. The most successful, Malaysia in 1995 had a per capita
income that was not far short of Korea.1
But this “economic miracle” came to an abrupt end in 1997 with the dramatic and totally unexpected
onset of the Asian financial and currency crises. These began on 2nd July 1997 with the collapse of the Thai
baht, quickly followed by the currencies of Indonesia, Malaysia, the Philippines and, even more surprisingly,
Korea. The currencies of the other Tigers remained relatively stable but in 1998 all the East Asian (with the
exception of Taiwan) and Southeast Asian countries experienced negative growth rates with output in
Indonesia collapsing by 14 per cent. The decline in growth had knock-on effects in the rest of the world,
reducing world growth by nearly a third in 1998. Any consideration of the East Asian miracle would be
incomplete without an examination of why this happened.
While the extent and speed of the Asian Crisis caught many commentators by surprise, so did the rapid
recovery. In 1999, the growth of GDP of the affected countries was Hong Kong 4.5 per cent; Singapore 6.7
per cent; South Korea 12.3 per cent, Taiwan 5.1 per cent; Thailand 7.7 per cent; Malaysia 8.1 per cent and
the Philippines 4.6 per cent. Only Indonesia was still stagnating with a growth of GDP of only 0.5 per cent,
but even this represented a massive improvement over the sharp fall in output during the previous year.
1
However, it should be remembered that not all the Asian countries have shared in this spectacular growth. The South
Asian economies of Bangladesh, India, Pakistan and Sri Lanka grew at only 2 per cent in terms of their per capita
income. Sri Lanka in 1995 had the highest per capita income of this group but even the value of that in 1995 was only
13 per cent of US per capita income.
The plan of this chapter is to first consider the factors underlying the sustained growth rates of the East and
Southeast Asian countries up until 1997. I shall then give a brief introduction to the causes of the Asian
financial crises and finally conclude with an assessment of the likely prospects for future rapid growth.
The Post-war Economic Success of the East Asian Economies
The rapid growth of the East Asian economies attracted a great deal of attention, mainly because it
was largely unexpected. The only comparable period of rapid and sustained growth during the last century
was that of Japan during the Golden Age from 1950 to 1973, and to a lesser extent the advanced countries
as a whole during this period.2
The fortunes of the region have attracted a great deal of attention because of the possible implications
they may have for increasing the rate of development in other less developed countries most recently the
Eastern European countries during their transition from Communism. A major debate was started by the
World Bank (1993) study and focussed predominantly on the relationship between government
intervention and the high-performance Asian economies (HPAE) (defined as both the East Asian and the
Southeast Asian economies) rapid economic growth. The major questions that have been asked include the
following:
- Was the rapid growth, for example, due to the fast adoption of new advanced technology, perhaps
largely imported from abroad or was it mainly due to simply a rapid growth of capital accumulation
(high investment rates) and a fast growth of labour?
- Was growth promoted by government policy, such as the targeting of potential growth industries and
the subsidising of exports? Given that there was a great deal of government intervention in some, but
not all, of the countries, was their fast growth rates because of or in spite of this? For example, in
Korea and Singapore the government intervened extensively, but in Hong Kong there was virtually no
intervention.
- To what extent was rapid growth due to Asian values and a financial system that was very different to
the Anglo-Saxon model?
- Why were there disparate performances amongst the Asian countries in their growth performance?
Another major issue was how long these fast growth rates could be sustained. Would the Tigers soon
follow the Japanese path which saw a marked deceleration of growth subsequent to 1973? This culminated
in a per capita income growth averaging less than 1 per cent over the four years from 1991-1995?
Some saw evidence that the growth rate was indeed beginning to falter before the onset of the Asian
crisis. In 1996, the export growth in East Asia was only 5 per cent, low compared with the 20 per cent
achieved in 1994 and 1995. The current account deficits as a percentage of GDP of Malaysia, Korea and
Thailand were in the range of 5 per cent to 8per cent, a level where the international financial markets get
distinctly nervous. Growth rates also in this year fell throughout the region, although to rates that the US
and Europe would be proud of. This led the Economist, prior to the Financial Crisis, to pose the question “Is
it Over?” and to continue “after years of extraordinary growth, East Asia’s emerging economies are
showing signs of fatigue. Are they exhausted? Or just resting before springing forward again?”
When is a Miracle not a Miracle?
In spite of the dramatic achievements of the East Asian Tigers in raising the per capita income of its
populations, in a well-known article, Paul Krugman (1994), drawing heavily on the empirical work of Alwyn
Young (1992), challenged whether it should even be regarded as a “miracle”. In other words, he argued
that the rapid growth could be readily explained in terms of orthodox economic theory without recourse to
such factors as the putative benefits of “Asian values” (soon to be transformed into the disadvantages of
“crony capitalism”).
Krugman’s polemical article challenged what had almost become the conventional wisdom that the
rapid growth of the East Asia would in the not too distant future mean that the centre of economic power
2
There was much greater variability in growth amongst the advanced countries. Although all the advanced countries
grew roughly twice as fast as their historic norms, the range in productivity growth was from Austria (4.9%) and
Germany (4.7%) to the UK (2.3%) and the US (2.2%). Japan’s productivity grew at over 8% per annum.
2
would have shifted from the West to the East. Likening this view explicitly to the erroneous one prevalent
in the 1950s concerning the rise of the USSR, Krugman saw a further parallel. The growth of the Soviet
Union was almost entirely resource driven. In other words, output growth was largely the result of the
rapid growth of labour and capital (with a large proportion of GDP being invested at the cost of reducing
the level of consumption at that time). There was little technical progress or, what is the same thing,
virtually no sustained increase in efficiency. This is not compatible with an indefinitely fast rate of growth.
The reserves of surplus labour in, notably, agriculture will become exhausted and there is a limit to
increasing labour participation rates. Furthermore, a high rate of capital accumulation by itself is not
sufficient for a fast sustained growth of output. This is because as the ratio of capital to labour increases,
diminishing returns set in and the rate of return falls. Eventually per capita growth will grind to a halt and
the economy will be in the classical economists’ dismal “stationary state”.3
Krugman argued that a similar fate to that of the Soviet Union awaited the East Asian economies to the
extent that their growth rate would inevitably fall. Recent work by Alwyn Young (1992) had suggested that
their growth was largely resource driven, a result of “perspiration” not “inspiration” as Krugman
memorably put it. This fact had been largely obscured by commentators concentrating on the very high
growth rates of output, per capita income, manufacturing output, and exports.
Moreover, once allowance had been made for the contribution of education, increased participation
rates and high levels of investment, the growth of total factor productivity, which is what really matters in
the long run, was nothing out of the ordinary.4
Table 1
Growth Rates of Selected Advanced Countries
Country Period
Output
growth
Japan
1967-1973
9.7
France
1965-1973
6.4
US
1960-1973
3.8
UK
1960 -1973
3.2
Table 2
Debunking the East Asian Miracle?
1966-1990
Per capita income growth
Total factor productivity growth
TFP
growth
6.1
4.3
1.5
2.0
Ratio of TFP
to output growth%
63
67
39
63
Hong Konga Singapore
3.4%
4.1%
2.3%
0.2%
Korea
4.1%
1.7%
Taiwan
4.0%
2.1%
For example, the TFP growth rates of Hong Kong, Korea and Taiwan, while respectable, are similar to
those experienced by some of the advanced countries (over period 1966-1989, Japan’s growth of TFP was
2.0 per cent; Italy’s 2.0 per cent, Germany’s 1.6 per cent and France’s 1.5 per cent North America had a
much lower TFP growth rate of about 0.5 per cent). However, they are well below those that the advanced
countries experienced as a whole during the Golden Age (See Tables 1 and 2). One most surprising result
Young found was that Singapore had grown from a relatively backward economy to an international city,
with one of the highest per capita incomes and with virtually no efficiency gains.
Some simply did not believe these results. One reason is that it has generally been assumed that the
successful developing countries would reap the benefits of the diffusion of advanced technologies that had
been developed in the more advanced countries. As most of the development costs had already been
3
In the long run (steady state) the growth of per capita income will be determined by the rate of technical change. A
high investment–GDP ratio will not lead to a faster steady state growth of output (except temporarily) but only to a
higher per capita income.
4
When considering growth rates, attention is often focussed on the growth of labour productivity (the growth of
output per worker) rather than just the growth of output. However, a better measure of economic performance is the
growth of total factor productivity. This is the growth of output per factor inputs (the latter being a weighted growth
rate of labour and capital). TFP growth is a measure of the rate of increase of the efficiency of the economy or the rate
of technical change.
3
borne by the advanced countries, their adoption would be picked up as an increase in efficiency or
technical progress. This is the “advantage of backwardness” to use Gershenkron’s phrase. Of course,
merely being backward did not mean that a country could automatically benefit. It needs as a prerequisite
the right “social capabilities” – an educated workforce, dynamic entrepreneurs, and a minimum level of
investment. Thus, the expectation was that the Tigers would have high rates of growth of total factor
productivity.5
The outcome of the controversy Krugman’s article generated has led, to a certain extent, to the reestablishment of the conventional wisdom. Critics have identified a number of problems with Young’s
results.
- Measurement problems. There are problems in measuring both output and the capital stock. Young
used value added as a measure of output and there are problems in using this as a measure of output,
especially when there is rapid product innovation (there are problems in adjusting for quality
changes).6 In much of the service sector, there is no independent measure of output. The growth of
the latter is often based on the growth of the input with an (arbitrary) allowance for productivity
growth There are often practical difficulties in measuring the capital stock, especially allowing for
quality change (are the high rates of investment due partly to the embodiment of advanced technology
from abroad?) and because of the lack of investment data for periods before the 1960s. This has
involved some crude extrapolation methods.
- The growth accounting results are not robust. Sarel (1994) finds that the TFP growth rates for the Tigers
are higher than Young’s and that the proportion of the contribution of TFP growth to output growth is
not much different from that of the advanced countries. Likewise a study by the UBS found growth
rates higher than those of Young for the East Asian Tigers. The exact calculations, though, are sensitive
to the time periods over which the calculations are made and the exact value chosen to weight the
-
and the period 1980-1990, the average growth of the four Tigers is 3.2 per cent per annum, whereas
-85 it falls to 1.0 per cent. Furthermore, evidence suggests that in Malaysia,
Taiwan and Singapore there has been a marked improvement in TFP growth from the mid-1980s
onwards.
The underlying assumptions are suspect. The calculations are based on the standard neoclassical
assumptions, including factors being paid their marginal products, perfect competition and neutral
technical change. These are not without their critics. Some criticise this within the standard neoclassical
paradigm. Nelson (1981) points out that if technical change is biased then the use of current factor
shares as weights is misleading as part will be due to the previous affect of the technical change and
this will lead to a bias in estimates of TFP. Others such as Pasinetti (1994) remind us that there has
been a very long controversy over the neoclassical production function and the theoretical criticisms of
it still stand. Whether they are important practically and whether the growth accounting approach is no
longer a useful starting point is another matter.
The upshot is that even if Krugman and Young are right in identifying that growth of East Asia was
primarily resource driven, there is still enormous potential for growth in the Tigers and an even greater
potential for catch-up in the Southeast Asian economies. The average Korean worker has still only forty
percent of the capital that an American worker does. Education, while well above the average for the less
developed countries is still below western levels. In 1994 the average worker only received seven years of
education (ranging from four years in Indonesia to 9 years in Korea) compared with 10 years in the
industrial countries.
How Important Was Government Intervention?
The other major debate is about the role of government intervention. The neoclassical (or free-market)
view sees the role of government to provide a stable macroeconomic environment (low inflation, no
5
The standard neoclassical model assumes that all countries have access to the same blueprint of technology and
therefore rules this out as a factor ab initio. An above average rate of growth of productivity is seen as being entirely
due to a temporary rapid growth in the capital-labour ratio until the steady state is reached.
6
Krugman himself cited this as a major problem in an earlier, more sceptical, comment on Young’s results.
4
excessive “unproductive” government expenditure and a roughly balanced budget). There should be as few
distortions in the economy as possible (through, for example, tariffs, quotas or subsidies). This would allow
price signals to direct private investment into the most profitable areas. A necessary corollary of this is that
the economies should become as open to free trade as quickly as possible. This would improve the
allocation of resources. It would also increase competition (and hence the efficiency of domestic firms) and
force them to improve their competitiveness through the adoption of more advanced technologies. These
beneficial effects would be accelerated if the countries also opened their economies to foreign direct
investment. This view is advanced by the World Bank and the IMF, who cite the examples of South Korea
and Taiwan in support of their view.
The alternative view (termed “revisionist” by the World Bank) came to quite the opposite conclusion.
By detailed empirical studies they showed that the HPAE governments did intervene quite extensively and
selectively. They targeted growth industries in which the countries did not necessarily have a comparative
advantage. These industries received subsidised domestic credit, R&D support, trade protection (usually
based on the infant industry argument), and state guidance on various aspects of marketing.
The World Bank in a subsequent research report (Page, 1994)7 conceded some ground to these
revisionist arguments, but tried to minimise their importance. The report echoed Krugman’s position that
the main engine of growth was rapid capital accumulation but it did find high TFP growth in East Asia.
While the report admitted that there was government intervention, it argued that this merely reinforced
the development of those industries that would have occurred as a result of comparative advantage
anyway. Government policies often used free market information and while intervention might indeed
have helped growth in the Tigers, the World Bank suggested that this was due to specific institutional
factors that were unlikely to occur elsewhere. Thus, the best course of action was still to let Adam Smith’s
“invisible hand” work, while pursuing an export orientation.
There is not space to go into this debate in any depth, but it should be mentioned that there is perhaps
a danger of over-generalisation. Perkins (1994)8 argues that there are three models of growth – (i) the
manufactured export-led state interventionist models of Japan, Korea and Taiwan, (ii) the entrepôt
commerce orientated economies of Hong Kong and Singapore and (iii) the resource rich (but human capital
poor) economies of Indonesia, Malaysia and Thailand. Nevertheless, it seems that ideology (the a priori
belief in the effectiveness of the free market or government intervention) plays a major part in the debate.
Whatever the view about Asia’s long-term growth prospects, there was little expectation at the
beginning of 1997 of the dramatic events that were just about to unfold.
The Asian Financial Crisis
The crisis began in July 1997, when pressure on the Thai baht became so severe that the government
was compelled to cease defending the fixed exchange rate and to let the currency float. There was rapid
contagion throughout the region leading to a collapse of the currencies of Indonesia, Malaysia, the
Philippines, and surprisingly Korea, all within a matter of weeks. Accompanying this were steep falls in the
affected countries' stock markets and this spread to other economies such as Singapore and Hong Kong,
whose currencies were the least adversely affected. (Hong Kong, which had a currency board, had
managed to defend the parity of its exchange rate.) The crisis very soon turned into a major world financial
crisis and substantially reduced world growth.
The crisis very quickly abated with the currencies stabilised and the stock markets and output showing
evidence of strong recovery in some countries. Nevertheless, the crisis had a dramatic effect on the
region’s growth rates. This may be seen from Table 3 which reports the growth rate of per capita income
for the five years prior to the crisis and separately for 1997 and 1998, together with the Asia Development
Bank’s (ADB) predictions for 1999 and the year 2000. The extent of the negative impact that the crisis had
on per capita growth rates is readily apparent, although these figures probably do not adequately convey
the disastrous social consequences that occurred in some of these countries, especially Indonesia.9 Why
then was this region, which, as noted above, some commentators regard as an economic miracle, plunged
into one of the world’s most serious post-war recessions?
7
J Page “The East Asian Miracle: An Introduction” World Development, (1994) vol. 22 pp. 615-625.
Perkins (1994) “There are at least three models of East Asian Development” World Development, vol. 22, pp.655-661.
9
See, for example, ADO (1999) Box 1.3, p.17, “The Social Impact of he Asian Economic Crisis”.
8
5
One possible explanation that can quickly be dismissed is that it was due to the exhaustion of
investment opportunities as a result of the high rate of capital accumulation. In other words, it was not the
outcome of the Krugman thesis discussed above. Krugman himself does not subscribe to this view and the
World Bank has shown that any likely slowdown in the productivity growth rates due to this cause is
several orders of magnitude smaller than that which actually occurred.10 Moreover, it is not clear why, even
if this was the cause, it should have hit Thailand and Indonesia the hardest - countries that have the largest
potential for catch up. It appears that it is necessary to look elsewhere for the answer.
The traditional causes of the combined effects of fiscal profligacy, a fixed exchange rate, and high
inflation can also be ruled out. This was the cause of the Latin
American crises of the 1980s and 1990s where the large budget deficits led to expansionary monetary
policy, domestic inflation, an appreciation in the real exchange rate, and resulting unsustainable current
account deficits. In fact, the East Asian macroeconomic indicators were generally healthy. The growth rates
were high, domestic savings and investment as a proportion of GDP were amongst the highest in the world,
and the fiscal balance was either in surplus or only marginally in deficit.11 The only cloud on the horizon was
the current account deficits which ranged from 8 per cent of GDP in Thailand to 3½ per cent in Indonesia.
(Singapore and Taiwan were the only exceptions, running substantial balance-of-payments surpluses of
15.4 per cent and 4 per cent respectively). However, such was the confidence in the region (albeit to come
to a sudden end) that not only did the capital flows cover these deficits, but they also were sufficient to
increase the official reserves.
Table 3
The Growth of Per Capita Income in the 1990s, Selected Asian Countries
Per Capitaa
GDP (US$)
East Asia
1991-96
1997
1998
1999b
2000 b
5.4
4.6
-2.8
2.1
4.1
Hong Kong
23900
3.3
2.2
-7.8
na
na
Korea
11900
6.0
4.5
-6.4
1.0
3.0
Singapore
22600
6.4
5.7
-0.9
-0.3
na
Taiwan
13200
5,3
5,9
4.0
4.1
5.5
3100
10.9
7.6
6.7
5.9
5.4
5.3
2.3
-8.4
-0.8
1.2
China
Southeast Asia
Indonesia
3800
5.8
3.3
-14.8
-1.5
0.5
Malaysia
10400
5.2
5.2
-8.4
-1.6
0.5
Philippines
2800
1.9
2.8
-2.6
0.3
2.2
Thailand
8000
6.7
-1.4
-9.0
-1.0
1.5
Advanced Countries
19400
It is now generally agreed that the proximate cause of the crisis was the rapid reversal of these shortterm capital flows. During the 1990s there had been a massive influx of short–term capital into the five
most affected countries (Korea, Indonesia, Thailand, Malaysia and the Philippines), which was made
possible by rapid financial liberalisation. These flows rose from $38 billion in 1994 to $78 billion in 1997,
but in 1998 this had turned into a net outflow of $12 billion (equivalent to 10 per cent of the GDP of the
affected countries). This outflow was not only due to foreign banks refusing to role over short-term loans,
but to a stampede of domestic holders into foreign currency. This placed huge pressure on the exchange
rates precipitating the spectacular falls.
There are thus two questions that need to be answered for an understanding of the crisis. First, what
was the cause of these increasingly large capital flows in the years immediately preceding the crisis and,
secondly, why was there this sudden capital flight?
10
The World Bank, East Asia, The Road to Recovery, Box 1.1 p.5.
The exception was Taiwan which was running a deficit of 6% of its GDP, but it will be recalled that ironically this
country was relatively unscathed by the crisis.
11
6
Each question is addressed in turn. The answer to the first is that in the early 1990s, East Asia proved
to be a very attractive home for foreign capital for a number of reasons. The countries had either implicitly
or explicitly linked their exchange rate to the US$ and were committed to defending this relationship. This
had, in the eyes of many foreign lenders and East Asian borrowers removed the element of risk due to a fall
in the exchange rate. There was also an expectation that the governments would always bailout any of the
large financial institutions, or firms that got into trouble. Financial crises in Thailand and Malaysia in the
mid-1980s and in Indonesia in 1994 had been resolved by government intervention and bailouts. This had
confirmed the view that the governments were implicitly underwriting the financial institutions and firms.
This weakened market discipline on the banks – if the government implicitly guarantees deposits, there is
no need for investors to withdraw them even if they believe the bank is behaving recklessly in, say, its
lending policies.
The perception of the region as one subject to sustained fast growth with high rates of return (which
were attractive as they were not seen as requiring a risk premium) led to a flood of foreign capital.
Liberalisation also led to greater borrowing from abroad by East Asian banks and firms. The banks
borrowed in dollars short term and then lent the funds long term in the local currency creating currency
mismatch. The belief that the exchange rate was fixed meant that there was no need to hedge and this
created a bias towards short-term borrowing. The large borrowing from abroad by the East Asian
corporations was also due to the high cost of intermediation by the region’s domestic banking system. It
was simply cheaper to raise funds from abroad.
The mechanism involved can be illustrated by considering a hypothetical capital inflow into Thailand. A
foreign (typically Japanese) bank makes a loan to a Thai “finance company”. The finance company, in the
words of Paul Krugman (1999) was to “act as a conveyor belt for foreign funds”. The finance company can
lend these out to local firms at a higher interest rate than it has to pay the foreign bank, but a rate that is
lower than other domestic sources from which the local firm can borrow. The finance company then enters
the foreign exchange market to buy baht using the borrowed yen. The Thai central bank is committed to a
stable exchange rate so that as the demand for baht increases, rather than letting the exchange rate
appreciate, it simply prints more baht. Thus, the foreign exchange reserves will rise and there will be an
increase in domestic credit, which with the operation of the money multiplier will be greatly in excess of
the original foreign loan.
The result was that in Thailand, with more and more foreign loans, there was a domestic credit
explosion. Some of it was spent on sound investments, but in other cases it merely fuelled asset and real
estate speculation. Any attempt to sterilise the inflow by issuing bonds in an attempt to mop up the extra
money merely drove domestic interest rates higher, making foreign borrowing even more attractive.
Eventually, the foreign loans and the consumer boom began to worsen the trade balance as exports
declined (because domestic costs rose) and imports soared. There was little concern from observers, as this
was perceived to be the result of private decisions, not excess expenditure by governments, and the
operation of consumption smoothing. The problem, however, as Krugman points out, was that the finance
houses were not like banks. They had few depositors to act as a check on their activities and the quality of
the loans they were making. Moreover, they were not specialists in advising firms as to the most profitable
use of these funds. But this was of little concern to the foreign banks who believed that because of the
close social networks between the finance houses and the Thai establishment, the Thai government would
bail out the finance houses should they ever run into difficulties. This is where the problem of “moral
hazard” comes in. The finance houses were quite happy to lend to highly speculative investors leading to
adverse selection of investment projects. If the investment was successful, then a substantial financial
profit would be made. If it failed, then there was no problem as the Thai government (and the Thai
taxpayer) would bail the finance house out and pick up the bill. A similar situation happened in the other
Southeast Asian countries, although the precise mechanisms were different.
The problems started with the beginnings of the (inevitable?) collapse of the stock market and real
asset bubble. There was a slowing down of foreign exchange coming into the country, but by this time the
import boom had taken off. There was still the need to exchange baht for foreign currencies and the Thai
Central bank had to intervene now to supply foreign exchange, and not to purchase it. With limited
reserves, there is clearly a limit to the extent to which it could do this. The government was also reluctant
to devalue the currency because of: (i) the opprobrium involved; (ii) the fear that the uncertainty
7
associated with a volatile exchange rate would damage exports and (iii) because so may firms’ debts were
denominated in foreign currency, they would become technically insolvent. The government could have
sharply increased interest rates to defend the currency but in the face of the slowdown, it was reluctant to
do this. (Moreover, as discussed below, once a speculative crisis is underway, increases in interest rates
become a particularly ineffective weapon.)
Once it was appreciated that the parity was indefensible, there were the conditions for a classic
speculative attack. There was an incentive to borrow baht to purchase foreign currency, say dollars, in the
expectation that after the devaluation the value of the dollars in terms of the baht would have appreciated.
Also, international banks worried about the impending crisis, refused to roll over the (short-term) loans
thereby forcing the financial houses to buy foreign currency to repay the debt. Some international hedge
funds also bought baht and entered the foreign exchange markets to buy dollars. The Thai government
clearly could not go on successfully defending the currency and, on the 2 July 1997, it bowed to the market.
But why did the collapse of the baht lead to a rapid contagion effect? After all the trade links between
Thailand and the other affected countries were not very great. The answer was that the financial markets,
not often renowned for their detailed understanding of the strength of the real factors underlying the
growth of a particular country, lumped them all together as “emerging markets”. Once one country had
reneged on both its commitment to defend the parity of its currency and its willingness to support its
financial institutions, then it became all the more likely that others would follow suit. But there was more
to it than just this.
The problem which was not appreciated until it was too late was that the rapid liberalisation of the
capital markets exposed some severe shortcomings of the East Asian financial system that only became
apparent with the benefit of hindsight.12 The problem was that much of the financial intermediation was
through the banking system. There were well-developed stock markets, but bond and other security
markets were underdeveloped and thus external corporate financing was largely through the banking
system. The debt to equity ratios were high throughout the region, and in the case of Korea reached 3.55 in
1996. The problem was that the banking system showed some fundamental weaknesses. The capital–
adequacy ratios were low, the legal limits on lending to single individuals or a related group were
unsatisfactory and not strictly enforced and there was lack of transparency in the banks operations. As the
World Bank commented:
“Weak governance of banks, often influenced directly or indirectly by government policies, added to the poor
performance. Perhaps the most important weakness was the limited institutional development of banks.
Much lending, for example, was done on a collateral rather than on a cash flow basis, thus obfuscating the
need to analyse the profitability and riskiness of the underlying projects. Credit tended to flow to borrowers
with relationships to government or private owners and to favoured sectors, rather than on the basis of
projected cash flows, realistic sensitivity analysis and recoverable collateral values”.
The problem here was that the banks appeared to be profitable and as the World Bank noted “the
costs to income ratios did not suggest gross inefficiencies.” Radelet and Sachs (1998) have commented
that, in terms of non-performing loans, the banks were actually in a better position in 1996 than compared
with two years previously. However, the fact that there were explicit government guarantees leads to the
problem of “moral hazard”. Since banks and companies are not likely to bear the cost of any failure, there
is the temptation to go for high return but risky investments. If the investments fail, they will not have to
bear the cost, which will be picked up by the government. (It is not only the East Asian governments’
guarantees that have been seen as causing problems of moral hazard. It has been argued that the IMF
bailout of Mexico in 1995 reassured Asian investors that they would be also rescued if there was a similar
crisis in the region.)
12
Stiglitz and Uy (1996) in a World Bank publication on government regulation of the East Asian banking system :
“Market failures are usually more significant in developing countries, and governments’ ability to correct them is more
circumscribed. What is remarkable is that East Asian governments took actions (such as prudential regulation) similar
to those taken by the more industrial countries, and they did so at an earlier stage of development. Moreover, these
regulatory initiatives succeeded without the abuses that often accompany them elsewhere.”
8
Thus, an explanation of the crisis is that in the early 1990s the massive capital inflows led to imprudent
lending by the domestic banks and a rapid expansion in credit leading to asset and real estate bubbles. The
latter encouraged further capital inflows. However, once market sentiment changed, a self-fulfilling
prophecy led to a vicious circle of capital flight, falling exchange rates and the collapse in the regional stock
exchanges. Once capital begins to move out of the region and the exchange rate begins to fall, no investor
wants to be caught holding assets valued in domestic currency. The capital loss caused by a depreciating
currency can far outweigh any possible gains in higher returns or in higher interest rates that are imposed
to try to restore confidence. As John Williamson has noted, 10 per cent devaluation in a week’s time would
require an interest rate of 14,000 per cent over that week to compensate the holder for not selling. The
fact that much of the foreign borrowing was short-term meant that the outflows were very rapid.
Moreover, they could not be covered by reserves. The interesting fact is that the ratio of short-tem
external debt to international reserves immediately prior to the crisis ranged from 2.44 in Singapore to 0.61
in Malaysia. It is this that is the common factor in the affected countries. Taiwan, which was not affected by
the crisis, had a ratio of only 0.24. While the existence of a high ratio is not a sufficient condition for a
currency crisis, it is probably a necessary one and it is a common factor that links all the crisis affected
countries.
All that was required for the crisis was a trigger; the crisis was an accident waiting to happen. Thailand
provided the trigger. First, through economic mismanagement Thailand had locked up most its foreign
reserves in forward contracts so that in fact far from having the $30 billion at their disposal, as the markets
initially thought, there was only $1.4 billion available, equal to the financing of just two days imports.
Secondly, the country’s struggling financial institutions had outstanding loans of over $8 billion from the
central bank. The costs of supporting these institutions became so high that at the end of June the Thai
government announced that it would no longer continue to support Finance One, the country’s largest
finance house. At a stroke this announcement effectively revoked the government’s commitment to act as
a lender of last resort and sent the risk premium sky high. It is no coincidence that 5 days after this
announcement, the Thai government was forced to float the baht rather than default on its international
loans. Once one country has abandoned a commitment to defending its exchange rate and bailing out its
poorly performing banks, it becomes easier for other countries to do so (the international criticism is
greatly reduced). Thus, the international markets also became increasingly nervous about the other
countries and the crisis spreads.
Three Generations of Models of Financial Crises
What is the Likely Impact of the Crisis on East Asia’s Growth Prospects?
Have the crisis-affected Asian countries quickly bounced back and resumed their rapid growth rates or
has there be a “lost decade of growth” as the necessary corporate and financial restructuring is
undertaken? Has the crisis harmed their growth prospects over, say, the next quarter of a century and will
there be slower growth henceforth in one or more of the countries, even after the region recovered from
the immediate aftermath of the crisis? (In particular, has the massive social dislocation in Indonesia
permanently harmed its growth prospects?) These are, of course, difficult questions to answer, as it is
necessary not only to assess the impact of the crisis per se on the long-term growth rates, but also to
speculate on what would have happened if there had been no crisis. Has the growth rate of the Southeast
Asian countries shown a secular decline as Krugman has argued will be the fate of the Asian Tigers?
The extent of the Asian crisis turned out to be as severe as the Latin American crisis of the 1980s, in
terms of the adverse impact on the output of the affected countries. As the World Bank noted, the decline
in industrial production in the region by about a fifth, was on a scale experienced by Germany and the
United States during the Great Depression of the 1930s. The negative impact on the growth of world
demand was comparable to the 1974 and 1979 shocks induced by the rise in the price of oil. But it is
important not to get the severity of the crisis out of proportion. The living standards of the region were still
higher in 1998 than ten years earlier. For many countries, the fall in output may only equivalent to the loss
of two or three years' growth.
9
State of Play – August 2007
Events in East Asia are changing fast. There has been a rapid bounce back in the fortunes of the region
that has been to many observers rather surprising. However, to the extent that the original crisis was
precipitated by “heard” instinct, it was likely that the collapse of the stock markets and real estate prices
were far greater than the underlying fundamentals of the economies would have warranted. The
consequent collapse of production was, therefore, also far greater than anyone could have foreseen. Given
the low base, it is not surprising that there should have been some recovery, but in a number of cases it has
been remarkable. Year-on-year increases during 1998/99 in industrial production were as follows:
Indonesia, 20 per cent; Malaysia, 16 per cent; Singapore, 7 per cent; South Korea, 24 per cent; Taiwan, 11
per cent and Thailand, 15 per cent. Only the Philippines missed out and industrial production here declined
by 11 per cent. The recovery in GDP growth rates was not quite so spectacular, but all countries grew by
more than 4 per cent (with the exception of Indonesia which could only manage 0.5 per cent). South Korea
managed to expand by a creditable 12 per cent. The stock markets have also rebounded. During 1999,
those in Thailand and Malaysia have doubled and Seoul’s and Singapore’s are now back to their pre-crisis
levels.
Moreover, the dire predictions by some commentators on the potential instability of the international
financial system caused by globalisation appeared to be unfounded. It is true that Russia did default on its
debt in August 1998 and while this may have been partly due to the Asian crisis, it occurred some 12
months later. The negative impact on the world economy of the Asian crisis was also partly offset by the
sustained boom in the United States. Moreover, the biggest threat to world economic growth, namely, the
collapse of the Chinese economy has not happened. The recovery seems to have been the result of
traditional economic mechanisms; households’ consumption had risen and firms began to invest again.
Also the East Asian governments adopted Keynesian expansionary policies with budget deficits running
sharply into deficit: Indonesia and Malaysia’s were as high as 6 per cent of GDP in 1999. Moreover, the
devaluations have led to a marked increased in export earnings in local currency terms, although not nearly
to the same extent in US dollars.
Nevertheless, many of the necessary regulatory reforms to the banking system and accounting and
bankruptcy proceedings have still a long way to go. The moral hazard problem of bank lending also needs
urgent attention. The great danger is that the recovery from the recession could remove the urgency from
these, paving the way for a repetition of the crisis in the not too distant future.
The Long-Term Prospects
Before looking at the likely impact of the Asian crisis on the region’s long-term growth rates, it is
instructive to consider what was likely to have been the growth prospects if the crisis had not occurred.
One way that this has been done is to use regression analysis to determine what factors have proved
successful in accounting for per capita growth rates in past periods.
The Asian Development Bank (1997), using data for the developing countries over the period 19651995 included such explanatory variables as initial schooling levels, policy variables (government saving,
degree of openness of the economy and institutional quality), various variables capturing demography and
“resources and geography.” The initial level of per capita income captured the “advantages of
backwardness”. This is simply the fact that the less developed countries are able to take advantage of the
more sophisticated technology that are developed in the advanced countries, either through diffusion or
via foreign direct investment. It is conditional, of course, on the existence of suitable levels of skills and
infrastructure being available to take advantage of this technology. (The initial level of per capita income
will also capture the effect of the transfer of labour from the low productivity agricultural sector to the
higher productivity industrial sector. The transfer is likely to be more important, the less developed the
country is and it will bring with it an increase in aggregate productivity for purely arithmetical reasons. The
scope for such gains will also decrease with development as employment in the agricultural sector declines
and productivity increases pari passu.) The importance of the initial per capita income is that it suggests
that growth rates are likely to slow down as a country’s per capita income converges with that of the more
advanced countries.
Table 4 reports the growth rates for the period 1965-95 and the predicted growth rates for the thirty
years 1995-2025. These figures are based on the assumption that all countries maintain the policy options
10
recorded in 1995. The table clearly shows the dramatic growth rates of the East Asian Tigers since the mid1960s.
It is perhaps forgotten these days just how underdeveloped, for example, Korea was in 1965 with a per
capita income level that was under 10 percent that of the US and not much above that of Bangladesh. Hong
Kong and Singapore have already overtaken the first industrial nation – the UK  in terms of per capita
income. In the time of one generation, the Tigers have raised their standard of living by an amount that
took the advanced countries several generations.
From Table 4, however, it can be seen that predicted growth rates of per capita income for the East
Asian Countries will decline by over half, largely due to the exhaustion of the scope for catch-up.
Nevertheless, this will not be sufficient to prevent them from catching up with, and in the case of Hong
Kong and Singapore, actually exceeding the US in terms of per capita income. The Southeast Asian
economies are now becoming closely associated with the Asian “miracle” because of their recent
spectacular growth rates. But their low level of development and per capita income must not be
overlooked – they still have a long way to go. Because of this, though, they are predicted to have actually
faster average growth rates over 1995-2025 than in the previous thirty years. Thus, the prognosis for these
countries
looks good (remembering, of course, that these estimates do not take into account the effects of the crisis.)
The scope for rapid growth is even greater in the South Asian countries, especially if they adopt more
policies to increase their degree of openness. Of course, there is nothing automatic about the pace of
development and the longer the growth rates are projected, the greater the scope for serious error, as the
case of Japan shows.
The World Bank has undertaken a similar exercise although using slightly different variables. For example,
variables such as the share of investment in GDP, and proxies for the sophistication of the financial system,
degree of corruption, and market distortions were included. Table 5 reports the implications of this study
for three countries: Indonesia, Korea and Thailand. The Table shows the differences to the per capita
growth rates each of the included variables makes in the decade 2000-2010 compared with the 1980s.
Table 4
Past and Predicted Growth of Per Capita Income for
Selected Asian Countries, 1965-1995 and 1995- 2025
GDP Relative to the US
1965-95
1995-2025
%
6,6
2,8
1965
17
1995
73
2025
98
Hong Kong
5,6
2
30
98
115
Korea
7,2
3,5
9
49
83
Singapore
7,2
2,5
16
85
107
Taiwan
6,2
3,1
14
56
88
East Asia
China
5,6
6
3
11
38
Southeast Asia
3,9
4,5
10
21
46
Indonesia
4,7
5
5
13
36
Malaysia
4,8
3,9
14
37
71
Philippines
1,2
5,3
11
9
28
Thailand
4,8
3,8
10
26
47
South Asia
1,9
4,4
8
9
21
Bangladesh
1,6
3,9
7
8
17
India
2,2
5,5
7
8
24
Pakistan
1,6
4,4
8
8
18
Sri Lanka
2,3
3,9
10
13
25
11
Table 5
Estimates of Per Capita Growth in
Selected East Asian Countries, 2000-2010 Relative to the 1980s.
Indonesia
Korea
Thailand
Initial Income
-0,7
-2,1
-1,3
Schooling
0.2
0.1
0.2
Investment
0.0
-0,4
0.0
Financial Depth
0.1
0.0
0.0
Economic Distortions
0.1
0.0
Fiscal Balance
0.2
0.1
0.1
0.3
Institutional Quality
0.3
0.3
0.3
Net effect
0.2
-2
-0,4
Per Capita Growth in 1980s
3.6
6.6
4.6
Per Capita Growth in 2001-2010
3.8
4.6
4.2
Table 6=Table3
It can be seen that the results also give rise to optimism about the about the future growth of these
East Asian economies. It is only in the case of Korea that there is a marked decline in expected productivity
growth rates (by 2 percentage points) but even here the growth is well above the average 1 per cent
achieved by the developing economies and would be the envy of most, if not all, the advanced countries.
The predictions include a return to the investment levels from the 1990s to the 1980s of 25-30 per cent and
hence this has a relative small part to play in the differences in growth rates between the two periods.
It can be seen that by far the largest influence on the productivity growth slowdown is the increase in
the initial level of per capita income and is to the very success of these countries and is thus to a certain
extent inevitable. However, to a large extent, this is very much a “black box”.
What difference, though, will the Asian Crisis make to these estimates? Table 6 shows per capita
income growth rates of the East and Southeast Asia in the 1990s.
The dramatic collapse in the growth of per capita income in 1998 following the decline in 1997 in
Southeast and East Asia is readily apparent; only Taiwan escaped unscathed. 1999 is likely to see still some
decline in per capita income, with small positive growth in 2000. The World Bank expects the long-run
output growth in East Asia (excluding China) post crisis to be substantially lower over the period 2001-07
than in 1991-97 which was “a period of exceptionally rapid investment and output growth even by East
Asian standards”. GDP in East Asia is expected to grow by about 5 to 5 ½ per cent per annum. (This
compares with 9 ½ per cent in 1991-1997). Long–run growth fundamentals are still intact - including high
levels of savings, human resources and openness. But investment rates are likely to be lower and there will
be more concentration on raising productivity growth rates.
Can Financial Crises be Predicted?
Conclusions
In this chapter we have examined various aspects of the East Asian Miracle and the Asian Crisis.
Whether or not one ascribes to the Krugman thesis, the growth of these countries certainly seems
miraculous. The Tigers achieved a rapid growth in per capita income and became effectively advanced
countries. The Southeast Asian countries still have a long way to go, but until the events of 1997, seemed
to be emulating the Tigers.
The Asian Financial Crisis exposed some fundamental weaknesses in the growth process, but not in the
underlying factors that gave rise to these growth rates in the first place. Rather it showed the dangerous of
rapid liberalisation of international financial flows before the domestic banking system has developed
sufficient regulatory control. The crisis is likely to cost the East Asian countries the equivalent of two or
three year’s economic growth, but there is no reason to expect that their long-term prospects have been
serious damaged provided the necessary institutional reforms are implemented. The danger is that the
recovery has come too early, if it removes the urgency about introducing these measures.
12