Causes and Impact of 1997 Asian Financial Crisis

03.11.2022 in Economics Essays
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In 1997, the Asian countries were struck by financial crisis that struck with an unexpected severity. Most of them were the admired nations that had emerged as successful in developing market economies. The Asian countries had realized rapid growth rates and drastically improved the living standards of the population (Sugisaki). In addition, they had established discreet fiscal policies and increased the rates of private savings. These nations were most admired and were widely seen as models to be emulated by many other countries. However, things changed so abruptly, and the same countries were entangled in the worst known financial crisis after the Second World War. The Asian economies had created a history of performing very well, but the crisis was so severe and unprecedented that some of them are still struggling to recover.

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Causes of financial crisis to the local economy

The Asian countries had operated in an environment of fiscal and monetary check, which led to high savings and investment rates, increased rates in growth, and low rates of inflation. The Asian countries then realized the rapid growth in asset values and stock and land prices. The successful history of the financial economies attracted foreign investors who underestimated the underlying economic weaknesses of the Asian countries (Sugisaki). They attracted foreign investors because of the economic success that brought high financial inflows. The inflows caused the Asian economies to experience a surge in capital inflows that were financing productive investments. Additionally, they developed policies and institutions aimed at safeguarding the financial sector. However, the policies and institutions that were put in place failed to keep up with the pace of the high demand. The inadequate policies could not respond to the demand which led to a financial crisis and economic disruption.

The weak financial systems of the Asian economies largely contributed to the financial crisis in the Asian countries. The policy limitation could not have caused alarm to the policymakers based on their past successes. In addition, this might give the reason why the government might not have created effective risk management to guarantee against failure. The ramifications only revealed with the deepening of the crisis. The weaknesses of the financial sector of the Asian economies were camouflaged by the rapid growth rates and the large capital inflows.

In the mid-1990s, some of the Asian countries faced external shocks. This led to the devaluation of the Chinese renminbi and the Japanese yen. This affected the prices of semi-conductors, which had great effect on the exports. These adverse effects led to the slowing of the economic activity and declining of the prices of assets in the Asian economies. However, Thailand was the worst hit when the foreign markets were affected and the Thai baht then collapsed in 1997 (Sugisaki). The collapse of the Thai baht was then followed by an extraordinary financial crisis in Asian economies.

Some of the causes of the Asian financial crisis were caused both by the external and internal factors. The Asian countries were developing economies and had carried out financial liberalization before the institutions were fully prepared to deal with the situation. The countries had opened themselves to possibility of shocks and instability caused by inflows and outflows. This had led to increased pressure that was evidenced with the large external deficits and the inflated prices of assets. The Bank of International Settlements shows that the total of US$ 184 billion entered the developing nations of Asia as private capital inflows by 1996. In 1997, before the crisis, additional US$ 164 billion were added to the economies. The high level of inflows placed pressure on the underdeveloped financial institutions. After the beginning of the crisis in 1997, US$ 102 billion moved out and the outflow continued. The volatile and sudden shifts of inflows and outflows had a great impact on the Asian economies.

The financial sector was made vulnerable by the maintenance that was dependent on pegged exchange rates used for foreign currency borrowing. This became unsustainable at certain levels and complicated the response of the monetary policies. One may argue that this was an implicit government guarantee against the risk of currency volatility and guarantees of exchange value. This lowered the cost of funding and encouraged further external borrowing that exposed the foreign exchange risk in the financial and corporate sectors. The borrowers were heavily exposed to foreign currency loans.

The Asian economies failed to implement hedging, which caused instability to the financial markets. The Asian countries used dollars to run account deficits, which led to decline in the value of the currencies. The lack of rules and poor supervision of financial systems led the policymakers to use measures that were unsustainable in adverse markets defending the exchange rates. The Asian governments guaranteed loans borrowed by private banks and financial institutions from foreign banks. This caused what Akerlof and Romer referred to as moral hazard crisis. This occurs when banks borrow funds on implicit or explicit guarantees of public utilities. The borrowed figures created currency mismatches, which forced the banks and corporate entities face pressure as asset values declined relative to liabilities. The measures led to high interest rates and a weakening in the quality of the banks loaning portfolios.

The problems associated with the uncertainties scared away foreign investors and worsened by lack of confidence and flight to quality. The speculative investors and foreign creditors feared to provide short term loans, and this affected the exchange rate of the Asian currencies and stock markets. The banks could no longer access overseas credits.

The external factors that influenced the Asian economies involved the foreign investors who had underestimated the economic risks of investing in Asian economies. They had put much of short-term capital flowing into the Asian economies to get quick and high returns. Out of the high inflow, only one to two percent was used for trading or direct investment. The remainder was used for speculation or short-term investments. The short term investments would move quickly and earn investors a lot of returns when the speculation was right. The foreign investors searched for high returns as investment opportunities were less profitable in Europe and Japan because of the slow economic growth and low interest rates (Sugisaki). The build-up of short-term investments led to sharp and sudden depreciation of their Asian currencies, which was combined with the lessening of the foreign reserves in attempts to reduce speculation. The short term private sector borrowing led to the increased debts in the Asian economies.

The Asian economies pegged their exchange rates in East Asia. The Asian countries created an open economy, and the high rate of liquidity injection destabilized the exchange rate. The open economies attracted foreign direct investments, capital inflows and outflows, and foreign trading. These transactions heavily relied on United States dollar markets to absorb their exports. It enabled the Asian economies to attract foreign investments and facilitate capital flows. In return, the currency exchange rates were aligned with the dollar which dominated the currencies. The dollar and yen exchange rates were unstable; that led to the buildup of the crisis because of the unsustainability. It resulted in uncertainty and speculative attacks on the Asian currencies because the demand for foreign currency could not be met. The dollar appreciated against the yen from 1995, and the countries with dollar pegged currencies lost their competitiveness. It led to export slowdowns in 1996–1997, which caused external imbalances that contributed to the financial crisis.

The foreign and local investors in some cases contributed to the financial crisis. The foreign and local currencies were exchanged for capital inflows and outflows. The inflows and outflows of funds were largely deregulated and allowed in the Asian economies. The foreign and local investors made efforts to cover the unhedged foreign currency after the beginning of the crisis which caused a downward pressure on the Asian currencies. They had difficulty in servicing the debts with some becoming bankrupt and worsening the financial crisis. The Asian domestic currency value of foreign debt rose sharply, making it difficult for corporate and financial sectors. The Asian economies faced contractionary shock because of the withdrawal of foreign financing.

The cause of the Asian financial crisis can be the Asian countries domestic policies and practices. However, the intrinsic and volatile nature of the global financial systems also played its role in the crisis. The global financial systems combined deregulation and market liberalization, which helped in interconnecting international markets. In addition, they assisted in the development of large institutional financial players in the market. The large institutions engaged in the market speculation where they are believed to have borrowed and sold Thai baht, and received US dollars in exchange. The depreciation of Thailand baht value led to much less dollar to repay the baht loans, and the financial institutions made large profits. The Asian countries’ financial institutions had over-speculated in real estate and share markets. The bad policies of having fixed exchange rates to the dollar led to high account deficits in the Asian markets.

The increased globalization of the world economy caused the Asian financial crisis to affect the economic development of the global economy. The crisis became region-wide and led many nations to the same outcome. It also greatly hampered the growth of the People’s Republic of China. The economic growth of China took a downward trend after the financial crisis, which was the result of slowed export growth. The rate of domestic economic growth regained when China’s government instituted effective measures to boost domestic demand.

The Asian financial crisis affected greatly the fixed asset investment in China. Its growth rate was 14.8% in 1996 but reduced to 8.8% in 1997. The private enterprises in China were affected by a significant decline in 1997. The growth rates of the enterprises in China dropped by 17.3%.

The resolutions of the 1997 Asian financial crisis

The crisis resolution procedures are required and implemented when the financial system is distressed. The Asian economies had weak financial systems that are believed to be the major cause of the Asian financial crisis. The lending institutions were not cautious when allocating credit, which led to the weaknesses that affected the Asian economies. The institutions also failed to exercise implicit or explicit government guarantees against such risks. It was necessary for reforms to be designed in ways that would strengthen the Asian financial systems. The Asian crisis was solved by the International Monetary Fund, which provided the Asian economies with loans to stabilize. The IMF loaned over $110 billion to the three most affected economies,, namely, Thailand, Indonesia, and South Korea.

The IMF responded to the Asian financial crisis by providing large-scale lending packages. The loans were conditional on putting into practice the macroeconomic and structural reform. The programs were intended to bridge finance to the debtor. The IMF uses them to enable the economies get into the reform process and help catalyze the private sector. To achieve its objectives the IMF uses programs based on policy components including fiscal policy, bank closure, tight domestic credit, debt repayment, nonfinancial structural changes, and capital adequacy standards. These programs proposed by IMF required from the Asian countries to adhere to strict conditions.

The IMF places fiscal policy as the most important program to ensure credibility. It was used in the Asian economy, and its purpose was to support money injection in the financial systems and protect the exchange rate. Some of the monetary and fiscal policies included the charge of higher taxes, reduced public spending, privatization and the charge of high interest rates. The IMF also enforced tough restrictions that required Asian countries to close illiquid financial institutions. A big number of financial institutions were liquidated and closed in the three most affected economies. The IMF enforced these actions to limit the losses faced and caused by the institutions. The implementation of these actions sent a strong message that the Asian governments had a positive growth. It also showed that they were serious about executing reforms to restore strong financial systems.

The other approach that could be employed was the private sector involvement in crisis resolution. The need for this is still debatable on the means and the best way to implement. Involving the private sector in crisis resolution limits the lending by the IMF. Eventually, the private sector would bail out the economies and assist in solving the crisis. The choice of using private sector in crisis resolution remains a choice of the debtor country and the creditors.

The private sector involvement provides both voluntary and involuntary options that are acceptable in the official finance community. The finance community helps to define the terms and conditions available and the limits attached to the finance. The debtor country is then given the option to decide which approach to take. The decision is based on the type of crisis that is there at the moment (Inaba 409).

Lessons learnt to prevent future financial crisis

The financial sector in Asia was complacent, hence making it prone to fragility. To prevent such incidents, it is necessary to understand the behavior of institutional investors and identify any source of potential future crisis. The Asian financial crisis taught important lessons that need to be applied today to avoid such events in the future. The government needs to engage in careful spending to avoid dictating on spending on public infrastructure projects and guidance of private capital into certain industries (Mishkin). The government involvement contributed to the effects in the asset and stock markets which was responsible for the crisis. The Asian implicit or explicit governments guaranteed financial institutions against loses, and they were not expected to bear the full costs of failure.The Asian governments encouraged lowincentive to manage risk effectively.

It is crucial to consider re-evaluating fixed exchange rates. Fixed exchange rates can be disastrous because the dynamics of the market requires flexibility to avert crisis like this. The Asian countries had fixed their exchange rates to the dollar and ran current account deficits. It caused a decrease in the value of their currencies by subjecting their currencies to downward pressure. Private Banks and other nonfinancial institutions borrowed large amounts from foreign banks in dollars which the Asian governments implicitly guaranteed. The loans were borrowed in dollars and lent to domestic institutions in local currencies. The exchange rate pegged to the dollar was predictable, which led to increased capital inflow and reduced the perceived risks.

After the crisis, the IMF was under scrutiny for its strictness in offering loans even to successful economies like South Korea. It agreed to support the Asian countries like Thailand, Indonesia, and South Korea but set tough monetary and fiscal policies to make the conditions to be met for the loans available. The critics of IMF stated that it had drifted from its mandate of assisting countries resolve their balance of payments problems. The institution has changed to be imposing economic, financial and social structures that are irrelevant to resolving the debt and balance of payments problems (Mishkin).

The investors need to be careful while investing in assets in the developing economies. The investments often end up failing, and the investors are caught unawares. The banking sector plays a major role in the financial sector. As the regulators, they are required to ensure there is transparency, and they thoroughly supervise the lending activity (Mishkin). The banking sector should pay particular attention to currency and maturity mismatches. The nations must adopt responsible institutions that are equipped to improve risk assessment and reduce leverage ratios.


The Asian crisis was as a result of the vulnerability of financial economies because of growing short term debts. Although the economic systems were weak, failure to comply with financial policies contributed to the detriment of the financial crisis. However, the worst of the crisis was avoidable through adjustments and making relative changes to the policies. The Asian economies were marred with macroeconomic imbalances at the macroeconomic level, weak financial institutions, corruption, and faulty legal bases in each of the countries involved. The problems facing the Asian economies required thorough analysis and corrective actions to rectify the challenge of vulnerability.

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