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East Asian crisis of 1997/1989 is listed among the most transmittable economic crises in the last two decades (Shambaugh & Yahuda, 2009, p. 5). Countries which were most affected include Malaysia, Indonesia, Philippines, Thailand and South Korea. However, the crisis also affected other economies like China, Singapore and Taiwan. This crisis started as a speculative attack on Thailand’s economy in mid 1997 but quickly spread to the neighbouring economies. By October 1997, Thai currency had fallen by approximately 40 percent, Philippine and Malaysian currencies by 30 percent and the rest of East Asian currencies by 35 to 40 percent against the American dollar.
The worst hit economies experienced grave socio-economic and political challenges (Lane, 1999, p. 5). This crisis later took a new dimension, commonly known as twin crisis. The policy response to the currency crisis later led to a crisis in the financial institutions. This took place mainly in South Korea, Malaysia, Thailand, and Indonesia. This crisis caused total chaos in Indonesia due to its impact in the political and economic front. However, Taiwan and Singapore escaped without dire consequences. Republic of China, particularly Hong Kong took ground-breaking steps to avert the effect of the crisis (Radelet & Sachs, 2001, p. 2).
The financial crisis was attributed to the advent of globalization. However, there are numerous alternative explanations on the cause of this crisis. Frankel and Kose (1996, p.352) attributed the looming crisis to flagging fundamentals. In other words, huge budgetary deficits, increased money supply, massive deficits in the current account, and reserve losses. They explain that when these principle elements are not consistent with monetary supply they can cause speculative attack.
Lane (1999, p. 8) attribute it to moral hazards such as lack of transparency which leads to selection challenges making the economy defenceless. These vulnerabilities can be hidden until the crisis hit. He also adds that economies’ inability to service outstanding short-term debts may have caused the crisis. Radelet and Sachs (2001, p. 12) argued that herding and panicking may have forced rational investors to pull out their investment in anticipation of the crisis. This paper will focus only on three countries: Malaysia, South Korea and Thailand.
Before the crisis, these countries were experiencing stellar economic growth. Their GDP grew very rapidly at two digits from 1990 to 1996. With their cumulative growth rate being over 110 percent in the seven year period, there is no wonder economists referred to them as miracle economies. However, when the crisis hit between 1997 and1998, these countries were most affected (Berger, 2003, p.388). Experts argue that the current account deficit might have played a huge role in the currency crisis in these three countries.
Prior to the crisis, these three countries had massive current account deficit. Their percentages were way above five percent which many would regard as very risky. It is believed that the high economic growth experienced in the three countries before the crisis was boosted by massive import of capital goods at the expense of exports. This may have contributed to the massive deficit in the current account (Calder & Ye, 2010, p. 25; McDougall, 2007, p. 5).
In addition, the gap between investment and saving may have also contributed to the current account deficit. Even though East Asian is generally well known for high saving rate, the high level of investment required to sustain the rapid growth rate during the seven-year period meant that the three countries were spending more than they were saving (McDougall, 2007, p. 6).
According to the theories of international economics, current account deficit should be equal to the current account surplus. Current account surplus is therefore the flipside of the current account deficit (Kevin, 2011, p.10). In the seven-year period (1990-1996), South Korea, Malaysia and Thailand had capital account surplus. In other words, they had strong capital inflows.
A large capital inflow is not necessarily an issue, but inflows (in forms of short term debts) can be very problematic to the economy. Given the high level of competition especially from the emerging Asian giants (Indian and China), foreign direct investment was declining thus necessitating these kinds of inflows to fuel rapidly growing economy.
In 1996, total foreign loan as a percentage of gross domestic products was estimated to be over 40 percent in Thailand, 25 percent in South Korea, and 22 percent in Malaysia (MacIntyre, Pempel & Ravenhill, 2008, p. 45). On the other hand, short term debts constituted more than 75 percent of the total loan in South Korea, 65 percent in Thailand, and 56 percent in Malaysia. Therefore, these countries relied heavily on short term loans to fuel their economies (Kevin, 2011, p.10).
The crisis was further aggravated by exchange rate regime and financial liberation (Calder & Ye, 2010, p. 26). Thailand, South Korea and Malaysia were on a quasi-peg system with their monetary policies being regulated within narrow bands. Even though quasi-peg system minimises currency volatility, local currency policies must conform to the pegged currency. Since all these countries peg their currency against the U.S dollar, their policies put a lot of pressure on the exchange rate.
Furthermore, the inflation rate for these countries was above 5 percent compared to the United State’s 2.5 percent (Calder & Ye, 2010, p. 27). As expected, the currency should have depreciated against the dollar. However, since the exchange rate system in these countries strived to stabilize the currency, it led to overestimation of currency values in a number of ways.
In addition to their low level of global reserves, the three countries became more vulnerable to speculative attack. The exchange rate vulnerability coupled with financial liberalization meant that the build-up in vulnerability was unavoidable (MacIntyre, Pempel & Ravenhill, 2008, p. 45).
The factors that precipitated susceptibility to the actual crisis were the speculative attack on Thailand’s currency in mid 1997. The early attack was massive and extended to other countries within East Asia. The crisis exposed Thai Central Bank which had reported deceptive figures on usable reserves (Lane, 1999, p. 8). The financial crisis was similar to the crisis that hit Mexico in 1995 and the difference was only on the excessive capital outflow.
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Within the first quarter of the crisis only, Thailand’s estimated capital flight was almost 30 percent of gross domestic product. This was way too high than the figure recorded in Mexico during the 1995 crisis (McDougall, 2007, p. 10). The excessive capital outflow was as a result of the response to the susceptibilities that had accumulated and at that particular moment, it was observed through depreciating currencies (Radelet & Sachs, 2001, p. 17).
The three main elements of this crisis were capital outflow, minimum reserves, and volatile interest rates. Having to defend capital flight that was destabilizing their currencies and low international reserves, the central banks in Thailand, South Korea and Malaysia had no other option but to float their currencies and increase interest rates to avert total economic breakdown. Given their exceedingly leveraged economies, increasing interest rates in these countries was very agonizing and had undesired effects (Calder & Ye, 2010, p. 29).
The initial currency crisis led into another crisis in the local banking sector. The real sector also felt the impact of the rising interest rates since the rate of defaulters also increased. The severity of this crisis was evident in contracted GDP. The average GDP growth for the three economies during the crisis fell below 9 percent in contrast to 11 percent witnessed before the crisis. The monetary sector also experienced similar radical contraction (Radelet & Sachs, 2001, p. 17).
Initially, Thailand, Malaysia and South Korea embraced policies that had contracting effect. The principle objective of these policies was to stabilize the economy. This lasted from August 1997 to almost September 1998. Afterwards, they started using expansionary/pro-growth policies (Berger, 2003, p.389). If the pace and extent at which these economies went down were astounding, the pace of their recovery was similarly astonishing. By August 1999, real GDP for these countries had become positive.
Economic growth in Malaysia, South Korea and Thailand got a boost from the strong growth in the global economy. With all of these countries witnessing positive growth in the economy, the recovery process was genuine. Undoubtedly, South Korea registered the strongest recovery (Calder & Ye, 2010, p. 30). Even though the macroeconomic policies embraced by these countries were the same, their policy response was not the same. Given the massive capital flight and its impact on the economy, these countries had to either avert the situation or find new inflows to prevent total economic collapse (MacIntyre, Pempel & Ravenhill, 2008, p. 46).
Malaysia opted to impose policies that regulated capital outflow and fixed its currency. However, Thailand and South Korea preferred the IMF route. In other words, they accepted huge financial packages from the International Monetary Fund. South Korea received 58 billion dollars while Thailand was given 36 billion dollars. Nevertheless, the IMF packages came with conditions. Besides the official financing, these countries (South Korea and Thailand) were required to adopt structural reforms and embrace new macroeconomic policies.
Even though the path chosen by these countries were not the same, their macroeconomic policies were almost similar (Radelet & Sachs, 2001, p. 17). The main aim of the IMF’s structural reform was leveraging. This was to be accomplished in two stages. First, these countries had to tidy up the mess created by the crisis, and this was to be followed by reinforcing the remaining structures.
The first step entailed resuscitation of the vital institutions and closing down the institutions that were not viable. South Korea and Thailand conformed to these standard procedures. However, Malaysia preferred a different path. It opted to absorb unviable institutions instead of doing away with them. The second part of structural reforms was largely the same in these countries (MacIntyre, Pempel & Ravenhill, 2008, p. 48).
From the study, it is very clear that before crisis started East Asian countries had started to show flaws and vulnerabilities. This conforms to a number of literatures explored in the current study. As noted earlier, the three main elements of the crisis were capital outflow, minimum reserves, and volatile interest rates.
Having to defend capital flight that was destabilizing their currencies and low international reserves, the central banks in Thailand, South Korea and Malaysia had no other option but to take necessary steps to avert the crisis. Even though these countries followed different paths to stabilize the economy, they employed almost identical macroeconomic policies.
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Calder, K. & Ye, M. 2010, The Making of Northeast Asia, Stanford University Press, Stanford.
Frankel, J. & Kose, A. K. 1996, ‘Currency crashes in emerging markets: an empirical treatment’, Journal of International Economics, vol.41, pp. 351-366.
Kevin, G. C. 2011, The Political Economy of East Asia: Regional and National Dimensions, Palgrave Macmillan, New York.
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