The Causes of the Asian Financial and Ec...
   1. Background to the financial and econo...
   2. Causes
   3. Effects of the Crisis


















 

The Causes of the Asian Financial and Economic Crisis

1. Background to the financial and economic turbulence of 1997-98

The period following the devaluation of the Thai baht on July 2nd 1997 witnessed a sudden and unprecedented collapse in asset prices, corporate and financial fragility, and a drastic economic slowdown in East Asian markets. In just over 12 months, the region's stock markets-once among the largest in the world-saw their market capitalisation shrink by as much as 85% in US dollar terms. Similarly, East Asian currencies depreciated sharply beyond the levels needed to maintain export competitiveness1, with some currencies falling by 50-80% against the US dollar by end-July 1998. East European and Latin American currencies also experienced some speculative pressure in the latter half of 1997, but generally fared much better. (See figures 1-3.)

Figure 1: Performance of Far East ex-Japan, Emerging Market and World stock price indices (Morgan Stanley Capital International Indices, US$)

Source: Datastream/ICV

Figure 2: Changes in local stockmarket capitalisation (US$, June 30th-December 31st 1997)

Source: Federation Internationale des Bourses de Valeurs (FIBV)

Figure 3: Performance of emerging market currencies against the US Dollar (July 2nd 1997-July 27th 1998)

Source: Datastream/ICV

The rapid depreciation in East Asian currencies, coupled with a plunge in asset prices in these countries, led to a fall in real purchasing power as inflationary pressures took root. Concurrently, there was a marked slowdown in economic growth: Asia's real GDP growth declined to 5.8% in 1997 from 6.6% in 1996, with a further decline to 4.1% expected in 1998 (see figure 4). Emerging markets took on an increasingly high-risk low-return profile (see figure 5) as rising volatility and the deterioration in economic fundamentals led to the outflow of capital from these markets.

Figure 4: Growth of real gross domestic output

Source: International Monetary Fund

Figure 5: Risk-return profile of stockmarket indices (December 31st 1997)

Source: Datastream/ICV

Attention had been drawn to the region some 18 months before the crisis broke as rising inflation, labour-market rigidities and substantial current account deficits suggested the possibility of growing complications associated with maintaining a rapid pace of economic expansion. By early 1997, both the Thai stockmarket and the Thai baht experienced increasing downward pressure, apparently over concerns of a continued accumulation in short-term foreign debt and the onset of property deflation. The country's large current account deficit was said to have raised urgent concerns that the baht would not be able to maintain its US-dollar peg in the face of speculative pressure, while the nascent problems in the local financial and property sectors were thought by some to have exacerbated the slide in its stockmarket.2 Although during the initial stages of the crisis the problem was largely regarded as being confined to Thailand alone, the Malaysian and Philippine stockmarkets also began experiencing selling pressure as the conditions in Thailand deteriorated. At the same time, the South Korean stockmarket began to falter with apparent concern over external imbalances, and a sluggish and increasingly financially-strained domestic economy.

The crisis was viewed by some as a serious threat to the stability of the region's financial system. In May both foreign and local players were thought to have amassed short baht positions in anticipation of a breaking of the baht's implicit peg against the US dollar. On May 14th, the Bank Of Thailand (BOT) was reported to have jointly intervened with the Monetary Authority of Singapore to defend the baht in the spot and forward markets. The BOT reportedly spent US$6.8b of its foreign exchange reserves in its defence of the local currency over the period January-June 1997, and another US$23b in forward sales transactions.

Soon after, the BOT introduced measures to discourage speculation on the baht. From May 16th domestic financial institutions were not allowed to lend or short the baht to non-residents nor buy back baht-denominated debentures before maturity. This effectively segregated the baht market into on-shore and off-shore tiers. On June 10th, the BOT went a step further and requested custodian banks and finance companies to remit foreign-currency proceeds from sales of securities belonging to foreign investors, and to transfer securities out of foreign investors' portfolios only for the settlement of sales transactions and not for securities lending purposes.

However, speculative pressure on the baht did not abate but rather intensified. After a massive depletion of its foreign reserves, on July 2nd the BOT abandoned its efforts to defend the baht and allowed the currency to be traded under a managed float.

Contagion quickly spread to the other three of the so-called ASEAN-4 countries, namely, Indonesia, Malaysia and the Philippines. The de facto devaluation of the baht drew attention to the viability of exchange-rate arrangements in other ASEAN-4 countries. The Malaysian ringgit and the Philippine peso in particular, which had been subject to only minor speculative pressure prior to the float, began to weaken significantly against the US dollar under intensified selling activity. This phase saw the first signs of global contagion, in the downward pressure on Czech and Slovakian currencies, although confidence in global financial markets appeared to hold steady overall. However, within the East Asian region, the Philippine peso, then the ringgit and finally the rupiah succumbed to speculative pressure in quick succession as their respective authorities eased their currency defence. Concerns over highly-leveraged corporate balance sheets was thought to have exacerbated the decline of these currencies against the US dollar. Currency and stockmarket volatility surged amidst uncertainty over these economies' exchange-rate policies (Figures 6 and 7).

On July 28th, Thailand requested technical assistance from the International Monetary Fund (IMF) and other parties; on August 20th, an agreement on a US$17.2b rescue plan was announced. By then, the turmoil had begun spreading to other parts of the region, although spill-over effects beyond the region still remained limited. Currencies and stockmarkets in Taiwan, Hong Kong and Singapore began to experience downward pressure while yield spreads on international bonds of Asian issuers widened considerably.

Figure 6: Volatility of global currencies (July 2nd 1997-July 27th 1998, annualised)

Source: Datastream/ICV

Outside the region, pressure on some currencies in Eastern Europe increased and Latin American Brady bond yield spreads grew wider. Heightened risk pushed emerging market borrowing costs sharply higher which impaired the ability of issuers to service their debt. However, other stockmarkets, especially those in the United States and Britain, continued to rise strongly despite a short-lived rise in global bond yields due to fears of a rise in European interest-rates.

The depreciation of many Asian currencies against the US dollar reinforced perceptions that other emerging market currencies were overvalued. In September-October, strong pressure mounted for the devaluation of these currencies in both spot and futures markets. The central bank of Brazil, for instance, was reported to have spent US$8.3b of its foreign reserves over this period to keep the real's exchange rate within its trading band under the crawling peg system.3 Faced with a plummeting rupiah and a corporate sector encumbered by a large short-term debt burden, the Indonesian government announced on October 8th its intention to seek financial support from the IMF and other multilateral organisations in an attempt to restore confidence in its economy.4

Figure 7: Volatility of Far East ex-Japan, Emerging Market and World stock price indices (Morgan Stanley Capital International Indices, US$)

Source: Datastream/ICV

Pressure also began to build on the Hong Kong dollar as fears grew over whether the Hong Kong Monetary Authority could maintain its currency arrangement against the US dollar. After a three-day decline in stock prices, during which the Hang Seng index lost more than 23%, these pressures eventually triggered a correction in stock prices world-wide. Concerns over the vulnerability of Hong Kong's stockmarket and currency, and the potential impact of the Asian crisis on corporate earnings in the United States was believed to have led to a 554.3-point or 7.2% plunge in the Dow Jones Industrial Average index on October 27th. The market's dramatic fall in the United States was echoed around the world, with most major markets consequently registering sharp falls that day or, in the case of the Asian markets, the next trading day. Emerging bond and stockmarkets suffered heavy losses as monetary authorities in several countries, including Brazil, Greece, Mexico and Russia, raised domestic interest rates sharply.

Most stock and derivatives markets reported a sharp increase in volumes during this period, despite the fact that price limits, trading halts and other forms of trading restrictions were activated in many exchanges as prices and index levels fell below pre-determined trigger levels. Although existing trading systems were reported to have, in general, functioned satisfactorily during this period of heightened market stress, liquidity in some emerging markets dried when excessive selling pressure emerged. Options trading on the South African exchange, for example, was said to have suffered a selling overhang as a result of surging volatility.

Developments in East Asia continued to have an affect on financial markets around the world through to December. European and American stockmarkets recovered by early December although lower bond yields and a rapidly-appreciating US dollar seemed to imply a continuing flight to safety from stocks in general.

Asian markets remained dogged by regional worries, which were now augmented by developments in South Korea and in Japan. Concerns increased over South Korea's difficulties in resolving its corporate debt overhang and in rolling-over financial-sector foreign debt. Shortly after the Korean government signed an agreement with the IMF on December 3rd for a US$57b5 aid package which placed tough conditions on economic reforms, it was revealed that the country's short-term foreign debt-at more than US$100b-was nearly twice as large as previously perceived.6

The closures of Yamaichi-Japan's fourth-largest brokerage-in early November and of Hong Kong-based Peregrine Investment Holdings in January 1998 added to concerns over the impact of the crisis on the health of some of the region's financial institutions. As the possibility of more corporate failures grew, East Asian currencies succumbed to intensified selling pressure and subsequently many of them-including the Malaysian ringgit, the Philippine peso, the Thai baht and the Indonesian rupiah-were driven down to historic lows by mid-January 1998.7

However, a raft of confidence-boosting measures announced by South Korea, Indonesia and Thailand in late January checked the downtrend. South Korea announced a series of liberalisation measures and financial reforms, including the closure of a third of its finance companies and a plan to allow small domestic companies to delay repaying more than US$533 million in foreign-currency debt8. In a similar vein, the Indonesian government proposed a temporary freeze on the servicing of private debt, in a bid to stem the rising number of bankruptcies and ease fears of further financial failures9. On January 30th, Thailand lifted its foreign-exchange controls, which had been in place since the previous May, as part of the conditions of its emergency aid package. Investor confidence subsequently turned for the better and the region's currency and stock markets surged up. Over the period February 2nd-3rd, the MSCI Far East ex-Japan Index rose by 11.9%, while the Malaysian and Hong Kong stock exchanges, for example, recorded massive gains of 23% and 14% respectively.

But the rally was short-lived. The renewed burst of buying activity quickly petered out because of concerns over the health of the some of the region's banking sectors in the face of mounting non-performing loans and an urgent need for re-capitalisation. Other factors included rising costs of servicing private sector debt and declining property prices.

Developments in Indonesia caught the world's attention in May as social unrest escalated with rising prices. Drastic increases in fuel, transport and electricity prices sparked student demonstrations, riots and looting in Jakarta. By mid-May, the situation deteriorated to such an extent that it brought business activity to a virtual standstill, and jeopardised the ongoing negotiations with international creditors to refinance short-term debts and stabilise flows of trade credit10. Increased demands for a change in the political leadership bred fears of further market turbulence, which made creditors increasingly reluctant to maintain their exposure to Indonesia.

Together, these factors added to the financial instability in Indonesia as well as in the rest of the region. President Suharto's resignation on May 21st spurred a brief rally in regional financial markets, although a delay in the resumption of financial aid to Indonesia cast a lingering pall over the region.

Confidence waned further as continued weakness in Japan's financial sector saw the yen decline to eight-year lows against the US dollar in mid-June. Concerns over the economy's exposure as a result of Japan's strong trade links with the United States, its large volume of lending to East Asian countries11 and prospects of an impending recession during the 1997/98 fiscal year were said to have pushed Japanese equity prices lower. Reports of a sharp rise in the so-called Japan premium appeared to reinforce concerns over bank profitability and credit availability in Japan.

On June 9th, China's central bank governor warned that the falling yen was having a "very negative impact" on China's foreign trade, capital inflows and economic restructuring, raising some concerns over the heightened pressure on the Chinese renminbi as well as on the Hong Kong dollar to devalue12. Consequently, the United States and Japanese governments jointly intervened to interrupt the yen's depreciation on June 17th. However, political uncertainty took hold when Prime Minister Ryutaro Hashimoto resigned from Japan's ruling party's presidency following its poor showing in the July 12th upper house parliamentary election.

Figure 8: Significant events as reflected by the regional stockmarket MSCI Far East ex Japan index, Jan 1st 1997 = 100

Source: Datastream/ICV and Securities Commission, Malaysia

Footnotes:

1. The Financial and Currency Turmoil in Asia: Origins, Contagion and Policy Responses, a report prepared by the Asian Development Bank for presentation at the APEC Finance Ministers Working Group Meeting, 16-17 February 1998, Vancouver, Canada.

2. On February 4th, leading property developer Somprasong Land became the first Thai company to default in a Euro-convertible debenture (ECD) interest payment when it failed to honour a US$3.1 million payment due on its US$80 million ECD issue. On Monday, March 3rd 1997, trading in the Stock Exchange of Thailand's banking and finance sectors was suspended for one day following the Bank of Thailand's call for an increase in reserve requirements for all financial institutions to re-establish flagging confidence in the financial sector. The sudden nature of the suspension forced at least one brokerage to temporarily halt all of its stock borrowing and lending activities on the Thai market. The SET president justified the unprecedented sector-wide suspension as a means of allowing investors time to analyse the implications of the new reserve requirements for the financial sector. Seven days later, the BOT and Thai Ministry of Finance (MOF) ordered ten financial institutions facing insolvency (including Finance One, the country's largest finance company) to raise additional capital within 10 days. Over the period June-August, a total of 58 finance companies had their operations suspended by the BOT and MOF and were ordered to submit rehabilitation plans.

3. This decline in reserves however, was temporal as the decisive interest rate hike in November 1997 and the subsequent policy measures undertaken by the Brazilian authorities saw its level of foreign reserves not only recovering, but by April 1998, Brazil's foreign reserves had surpassed its pre-crisis level. At the end of September 1997, operational foreign reserves amounted to US$61b, corresponding to 12 months of imports. The level of reserves dipped to US$53b at the end of October but from the beginning of 1998, Brazil's stock of foreign reserves steadily increased, reaching almost US$74b or 15 months of imports by the end of April 1998.

4. On November 5th, the IMF's Executive Board approved financial support of US$9.9b to be disbursed over a three-year period. In addition, US$26.7b was pledged by other multilateral organisations, bringing the total financial aid rendered to Indonesia to US$36.6b.

5. This amount consists of US$20.9b from the IMF, US$14b from other multilateral organisations such as the World Bank and the Asian Development Bank and US$22b from industrial countries such as Australia, Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States.

6. Short-term debt constituted about 55% of South Korea's entire foreign debt burden.

7. The Indonesian rupiah subsequently depreciated further against the US dollar to new historic lows in June 1998.

8. January 30th 1998.

9. January 27th 1998.

10. During this period, some brokers reported that they had stopped taking orders because of the high risk of non-settlement. On May 14th-15th, the central bank suspended clearing operations for foreign exchange transactions as its staff stayed home due to rioting and looting throughout the city. The resultant sharp decline in currency market liquidity greatly exaggerated swings in the rupiah, with the currency appreciating by as much as 15% against the US dollar in early trading on May 15th.

11. Bank of International Settlements data indicate that Japanese bank-lending to the five most affected countries stood at about US$100b at end-June 1997, equivalent to about 3% of the banks' risk-weighted assets.

12. While some analysts took his remarks, the first by a senior mainland official acknowledging the damage inflicted by the weakening yen, as an indication of the high cost borne by the Chinese economy due to its earlier pledge to the G-7 governments not to devalue the renminbi at that juncture, others believed that the importance of the yen's decline was overstated.

Case Studies * The Causes of the Asian Financial and Economic Crisis