South East Asian Currency

Crises
MACROECONOMIC THEORY AND POLICY

By

Jairaj MVB14147
Kiran Mettayil Chacko B14151
Manjot Singh SainiB14152
Monish Agrawal
B14156
Divya Aggarwal
F14007

CONTENT

ONSET OF A CRISES
For any loan agreement there are two parties: Debtors and Creditors. Every time the blame of a financial crises
falls on the shoulder of a debtor. However we fail to analyze that miscalculations have been done by both the
creditors and the debtors. Similarly the East Asian Crises was caused due to shortcomings from both the
economy (debtor) and IMF (lender).
In any emerging market financial crises, an economy that has been recipient of large scale capital inflows stops
receiving such inflows instead faces sudden demands for the repayment of outstanding loans. This reversal of
cash flows leads to financial meltdown which leads to a crises. It can be said that the onset of a crises is based
on:
-

Abrupt changes in international market conditions that affect the ability of debtors to repay outstanding
loans, such as shifts in interest rates, commodity prices or trade conditions
Abrupt shifts in the debtor country that cause creditors to reassess that countrys ability or willingness to
service foreign debt

WHAT HAPPENED WITH ASIAN TIGERS IN 1997-98 MIRACLE BECAME A MIRAGE

Booming Economies:
In the 1990s, South East Asian economies of Thailand, Malaysia, Singapore, Indonesia, Hong Kong, and South
Korea had booming states of economy with a GDP growth rate of 6%-9% per annum. The key factors for the
growth were:
- Export orientation - due to inexpensive and relatively well educated labor, falling barriers to
international trade, heavy inward investment by foreign companies
- Export led growth led to soaring commercial and residential real estate prices
- Continued increased in wealth led exporters make bolder investments in industrial capacity
- Augmented by ambition of chaebol (South Koreas giant diversified conglomerates)
- Huge infrastructure projects by the government
- Encouragement by government to private businesses to invest in certain sectors in lieu with national
goals
These economies moved from low technology manufactured export activities to high technology products. The
outward oriented industrialization strategy depended fundamentally on four core macroeconomic policies:
- High rates of government and private savings
- Reliance on private ownership in the industrial sector
- Low inflation rates and restrained domestic credit policies
- Convertible currencies, with low or zero black market premiums on foreign exchange
From Boom to Bane:
What went wrong was the financing of the extraordinary growth mission plan with borrowed money.
A sophisticated and well regulated financial services system is required when the production process becomes
more complex and connected with world economy. With the growth in the economies, the Asian tigers were not
able to effectively regulate and supervise their financial services. Hence they became vulnerable to external
financial shocks. The high foreign capital inflows lead to appreciating real exchange rates, rapid expansion of
bank lending thus making the economies more vulnerable to reversal in capital flows. The key factors for the
crises were:
- Extremely high annual capital inflows of ~6% of GDP in 1990-96 in the five economies Indonesia,
Korea, Malaysia, Philippines and Thailand

Maintenance of exchange rate with little variation by the government, led central banks to absorb the
risk of exchange rate movements on behalf of the investors which encouraged high capital inflow
especially with short term maturities. Pegging local currency to USD increased the size of dollar loans
burden when the local currencies started to depreciate against USD.
Exchange rates appreciated in real terms as the capital inflows put upward pressure on the prices of
nontradables. This raised borrowing costs leading companies to default on debt payments.
Export growth measured in USD, began to slow in the mid-1990s and then dropped sharply in 1996
Domestic bank lending expanded rapidly throughout the region
Rising share of foreign borrowing was in the form of short term debt
Heavy investments in infrastructure lead to surplus capacity moreover such investment came at the cost
of heavy foreign imports as well. The growing imports started building up balance of payment deficits.

There were two reasons for it:

- Unfavorable Macro developments Capital inflows, real exchange rate appreciation
- Unfavorable Micro developments Credit expansion, financial regulation and supervision
In economic terms, the primary reason why markets fail in this way is due to collective action. The collective
action of foreign creditors sparked the crises which led to withdrawal of capital from the region and mounting
pressure on exchange rate.
CRISES AFTERMATH

The crises engulfed all the East Asian Tigers, due to:
- Common causes: movements in the yen-dollar rate and other terms of trade shocks
- Spillover effects: through trade and financial linkages
- Contagion effects: Crises in one country served as a wake up call and forced market recognition of
similar financial and institutional weaknesses in the crises countries
To counter the crises governments intervened in the foreign exchange markets to defend the rate coupled with
short lived hikes in interest rates and adopting floating exchange rates. However these initial responses failed to
restore investor confidence and capital outflows; leading to seek support from the IMF. The Funds adjustment
programs were focused on restoring investor confidence specific to each country. The key initiatives were:
- Strengthening the financial sector, and improving the efficiency of financial intermediation
- Improving the functioning of markets including by breaking the links between business, banks and
government
- Enhancing transparency with regard to the disclosure of key economic, financial and corporate sector
information
- Tightening the social safety net
IMF: WHITE KNIGHT OR DARK KNIGHT

The original charge of the IMF was to lend money to member countries that were experiencing balance of
payments problems, and could not maintain the value of their currencies. The idea was that the IMF would
provide short term financial loans to troubled countries, giving them time to put their economies in order. As a
result of the Asian crisis, in late 1997 the IMF found itself committing over $110 billion in short term loans to
three countries; South Korea, Indonesia, and Thailand.
As with other aid packages, the IMF loans come with conditions attached. The IMF is insisting on a
combination of tight macro-economic policies, including cuts in public spending and higher interest rates, the

deregulation of sectors formally protected from domestic and foreign competition, and better financial reporting
from the banking sector. These policies came at a cost to the Asian Tigers:
- Tight macro-economic policies are inappropriate for countries that are suffering not from excessive
government spending and inflation, but from a private sector debt crisis with deflationary undertones;
the tight policy increased the short term interest rates putting pressure on debt repayments
- It is said the IMF created a moral hazard, it arises when people behave recklessly because they know
they will be saved if things go wrong. By providing support to these countries, the IMF is reduced the
probability of debt default, and in effect bailed out the very banks whose loans gave rise to this situation.
With continued capital outflows and falling exchange rates, the countries experienced much deeper recessions
than projected. This reflected mainly a collapse in domestic spending, especially private investment. The
countries underwent enormous current account adjustments, associated mainly with sharp drops in imports.
LESSONS LEARNT FROM THE CRISES

The East Asian crises came as a surprise to everyone and highlighted the risks associated with doing business in
developing countries. The euphoria of growth was shattered by the crises. However, lessons are learnt from
history, the crises made academicians think on what went wrong and what could have been to prevent it. In
simple terms lessons we can learn from the crises are:
1. Preventing or reducing the risk of crises: At national level policies
a. Avoid large current account deficits financed through short-term, unhedged capital inflows : this
can be done by securing adequate foreign exchange reserves, maintaining sound fiscal and
monetary policy, adopting a viable exchange rate regime and establishing an orderly capital
account liberalization
b. Aggressively regulate and supervise financial systems to ensure that financial institutions manage
risks prudently : Improve information transparency and introduce limited deposit insurance along
with allowing prudential regulations as financial safeguards and cushions
c. Erect an incentive structure for sound corporate finance to avoid high leverage and excessive
reliance on foreign borrowing : Promote better information disclosure and establish good
corporate governance
2. Managing crises:
a. Mobilize timely external liquidity of sufficient magnitude : Restore market confidence and reduce
moral hazard problems
b. Do not adopt a one-size-fits-all prescription for monetary and fiscal policy: Adopt appropriate
monetary and fiscal policy contingent on the specific conditions of the economy
c. Bail-in private international investors : Impose official stand stills and in extreme cases, allow
involuntary private sector involvement
3. Resolving the systemic consequences of crises
a. Move swiftly to establish resolution mechanisms for impaired assets and liabilities of banks and
corporations : Establish procedures for bank exits, recapitalization and rehabilitation along with
establishing frameworks for corporate insolvencies and workouts
b. Cushion the effects of crises on low-income groups through social policies to ameliorate the
inevitable social tensions: Strengthen social safety nets to mitigate social consequences of crises

THAILAND
Thailand is a country at the centre of the Indochina peninsula in Southeast Asia. Thailand experienced rapid
economic growth between 1985 and 1996 averaging 9.8% annually, becoming a newly industrialized country
and a major exporter. Manufacturing, agriculture, and tourism were leading sectors of the economy.
Many different factors contributed to the rapid growth of Thailands economy from 1985 to 1996. Low wages,
policy reforms that opened the economy more to trade, and careful economic management resulting in low
inflation and a stable (fixed) exchange rate. These factors encouraged domestic savings and investment and
made the Thai economy an ideal host for foreign investment. Foreign and domestic investment caused
manufacturing to grow rapidly, especially in labor-intensive, export-oriented industries, such as those producing
clothing, footwear, electronics, and consumer appliances. These industries also benefited from a tremendous
expansion in world trade during the 1980s. As industry expanded, many Thai people who previously had
worked in agriculture began to work in manufacturing, slowing growth in the agriculture sector. Meanwhile,
manufacturing growth spurred the expansion of service sector activities.
The graph below shows the growth of Thailands GDP from 1985 to 2014

The graph below depicts the growth rate of GDP of Thailand from 1985 to 2000

BEGINNING OF THE CRISIS

Prior to the crash as mentioned above the Thailands economy was performing exceedingly well and became a
darling of the economists and journalists. It was among the first Southeast Asian countries to overcome the
economic downturn of the mid-1980s. It was able to attract enormous inflows of foreign investment especially
from East Asia, and the economy boomed. Unfortunately, the episode was also characterized by a bubble and
massive speculation, where investments were made with little regard to sound and supportive economic
fundamentals. Hence the pressure increased on Thailand's currency, the baht, in 1997, the year in which the
economy contracted by 1.9%, leading to a crisis that uncovered financial sector weaknesses and forced the Thai
administration to float the currency. The baht was pegged at 25 to the US dollar from 1978 to 1997; however,
the baht reached its lowest point of 56 to the US dollar in January 1998 and the economy contracted by 10.8%
that year, triggering the Asian financial crisis.

REASONS THAT LED TO THE CRISIS

The crisis in Thailand stemmed primarily from large current account deficit making the currency vulnerable to
speculative attacks. Thailands deficit was 8 percent of GDP in 1995; 7.9 percent in 1996 and 1997 (Far Eastern
Economic Review, January 15 1998). And the export growth rate decreased by 23.5 percent between 1995 and
1996. The deficits caused the country to rely heavily on external borrowing.
Secondly, excessive external debt, in 1997 the International Monetary Fund (IMF) estimated that Thailands
external debt was about $U.S.99 billion i.e. about 55 percent of GDP. The majority of this debt was privately
incurred and this large external debt sharply lifted the countrys debt service ratio from 11.4 percent in 1994 to
15.5 percent in 1997
Thirdly, the collapse of the property sector: The Thailands property market boomed started in the late 1980s.
With the liberalization of international capital flows in 1993 this sector grew rapidly. By 1995, an oversupply of
housing emerged, expanding into a major problem. With loans increasingly becoming more expensive and hard
to get under the Bank of Thailands squeeze on lending, the property sector began to collapse in 1996. The
property sectors debts totaled around 1,000 billion baht in 1996. The slump in the property sales market and
lending squeeze worsened the developers cash flow troubles and defaults on interest payments. As a
consequence many finance companies and small banks faced liquidity problems, with 16 finance companies
suspended in June 1997, and another 42 in August 1997. By December 1997, 56 finance companies were closed
permanently.
Fourthly, exchange rate mismanagement, with a fixed exchange rate and the liberalization of international
capital flows, foreign money poured into Thailand between 1993 and 1996. As a result the Thai baht became
overvalued against other currencies, partly slowing down growth in exports in 1996. Hence the speculators
attacked the baht in February and May 1997 and in order to defend the currency, the Bank of Thailand used
official foreign reserves. The net result being that official foreign reserves fell from $U.S.39 billion in January
1997 to $U.S.32.4 billion in June 1997. Additionally, the Bank of Thailand sold $U.S.23.4 billion of the
reserves on the forward market. In July 1997, 12 the Bank of Thailand had to replace the fixed exchange rate
with a managed float, as it could no longer tap the reserves. The exchange rate for the baht has fallen steadily
since then from 25.8 baht to the $U.S. to around 40 Baht to the $U.S. currently, with the Baht reaching 50 Baht
to the $U.S. before settling at its current level. The mismanagement of the exchange rate system has been cited
as evidence of central bank incompetence (Thammavit, 1998).
Finally, political instability, poor economic policies and short sighted policy making were also some of the
major reasons behind the crisis
EFFECT OF THE CRISIS

The crisis led to huge devaluation of Thai currency Baht, which made the foreign debt too expensive. It led to
the contraction of the economy of Thailand in the year 1997 by as much as 10%. The exports nose-dived and
this created a huge current account deficit and the foreign exchange reserves of Thailand virtually evaporated. It
hence necessitated IMF-led bailouts.
Finally it led to restructuring of the Thailands economy and the financial sector.

As mentioned earlier the IMF-led bailouts did not come unconditional. The IMF lent Thailand $17 billion on 11
August 1997 but the support was conditional on a series of economic reforms, called the "structural adjustment
package" (SAP). The SAPs called on crisis-struck nations to reduce government spending and deficits, allow
insolvent banks and financial institutions to fail, and aggressively raise interest rates. The reasoning was that
these steps would restore confidence in the nations' fiscal solvency, penalize insolvent companies, and protect
currency values.
It called for Thailands government to pass laws relating to bankruptcy (reorganizing and restructuring)
procedures and establish strong regulation frameworks for banks and other financial institutions.
THAILANDS ECONOMY NOW

A decade on from the financial crisis of 1997, Thailand finds itself in the midst of another crisis, this time a
political one. Although the economy has been suffering from a downturn in business confidence in the wake of
the September 2006 military coup, Thailand's economic fundamentals are nevertheless generally strong. Indeed,
rather than battling the markets to prop up the baht, the Bank of Thailand (BOT, the central bank) has been
under pressure to weaken it. In order to do so, in late 2006 the BOT imposed controls on the inflow of capital.
The baht now stands at a nine-year high of around Bt34.5:US$1 on the local market, and on the offshore market
it has risen to Bt32.3US$1.
The country's external accounts are far healthier: the current account has been in surplus every year since 1997
except 2005; foreign-exchange reserves have soared to US$71bn, up from the 1997 low of US$26bn reached
when the BOT gave up its costly efforts to keep the baht fixed to the dollar; and external debt levels have
dropped sharply, with most of the private sector's short-term debt taking the form of trade credits rather than
loans, a reversal from the pre-1997 situation.
The banking sector has also recovered well, with NPLs dropping to around 4-5% of total outstanding loans--a
decade ago the ratio was close to 50%. A process of consolidation in the banking sector has also been under way
since 2004, and regulatory standards and bank lending practices have improved markedly.
INDONESIA
THE CRISIS

The Crisis in Indonesia was largely due to the contagion Effect of the Asian Financial Crisis started on July 2
1997, when the Thai Government burdened with huge financial debt decided to float its currency (which was
earlier pegged to Dollars). This monetary shift was aimed at stimulating export revenues but proved to be in
vain. It soon led to a contagion effect in other Asian countries as foreign investors - who had been pouring
money into the 'Asian Economic Miracle countries' since a decade prior to 1997 - lost confidence in Asian
markets and dumped Asian currencies and assets as quickly as possible.
Indonesia was the far worst affected economy in the Asian crisis, with the severity of the crisis coming as a
surprise to many observers. In fact very few predicted the crisis in Indonesia even after the devaluation of the
Thai bhat in July 1997. It was instead argued that the crisis would not have not have any significant impact on
Indonesia because of its sound macroeconomic fundamentals. Indonesia enjoyed the highest economic growth

in South East Asia, low inflation, a relatively modest current account deficit, rapid export growth and growing
international currency reserves. Foreign investors initially kept confidence in Indonesias ability to weather the
economic storm (as it had in 1970s and 1980s). However this time it became the hardest hit country as the crisis
not only had economic but also far reaching political and social implications.
MAJOR CAUSES OF CRISIS IN INDONESIA

Indonesias Macroeconomic vulnerability to crisis

The real effective exchange rate of a country is determined is determined by its capital inflows and exchange
rate regime. A stable exchange rate attracts foreign investors. Before the crisis, the exchange rate regime in
Indonesia was managed by its central bank which allowed the exchange rate to float within a band around a
target. Although Indonesia widened the exchange rate intervention band from 0.5% in 1992 to 8% in 1996,
fluctuations in the nominal interest rates were limited to around 4% annually, indication that the central bank
was able to control the exchange rate movements. The stable Indonesian exchange rate appealed to foreign
investors and led to a large increase in capital inflows which contributed to a slight appreciation in real effective
exchange rates in 1996.
The exchange rate regime worked relatively well with a stable or even depreciating US dollar, but the regional
currencies appreciated slightly along with the US dollar in 1996. This appreciation was accompanied by the
entry of new competitors such as China, Vietnam, and India, which liberalized their economies in 1990s and
became successful exporters of goods. As a result of these factors, export growth decreased for Indonesia from
an average 13% between 1990 and 1995 to 10% in 1996(however, this was lower than in most of the remaining
ASEAN countries)
The slowdown in the export growth aggravated the existing trade imbalances, fuelling larger current account
deficits in the region as a whole. However, for Indonesia, despite the real effective exchange rate appreciation,
new competitors and an oversupply of certain important export goods the current account deficit remained at a
stable 2.5% of GDP between 1990 and 1996. It was not the size of Current account deficit which precipitated
the crisis, but the way it was financed. Long term capital inflows, such as foreign direct investment, are
relatively stable and tend to remain in a country once they have been introduced. On the other hand, short term
dents increases the vulnerability to shifts in investor willingness. High Indonesian interest rates encouraged
short term capital inflows. The Government at that time wanted to curb an overheating economy by raising the
interest rates. However the short term capital inflows limited the effectiveness of tight monetary policy.
Therefore the restrictive economic policy through higher interest rates failed, since capital inflows increased
domestic liquidity and thereby economic activity. Also Indonesia restricted to finance its current account deficit
through FDI due to political reasons and thus went for large short term capital inflows. High short term debts to
international reserves increased the risk for a country of not fulfilling its debt payments in the event of a creditor
run. In Indonesia, the ratio of short term external debts to international reserves was high, particularly compared
to other countries in 1996
Another related factor of financial fragility was ratio of M2 to international reserves. If a currency crisis or
financial panic occurs, all liquid money could potentially be converted into foreign exchange. The ratio between
M2 (broad money supply) and international reserves was particularly high for Indonesia (6.5)

Effect of Investors Behavior

Japan, which was the major lender to Indonesia (accounted for 35% in Indonesia) had been in an economic
recession since 1991 and the recession worsened in early 1997. The Japanese banking sector was severely hurt
by the recession and many banks experienced capital losses and were required to rebalance their loan portfolios.
The Japanese banks were the first ones to pull out of South East Asia and this withdrawal exacerbated economic
condition in Indonesia.
In addition, imperfect information may have led investors to consider that Indonesia and Thailand had similar
problems, causing them to withdraw their Indonesian funds. Although Indonesia had better economic
fundamentals than Thailand, the low ratios of international reserves to short term debts or to broad money
supply were troublesome features of the economy. The crisis in Thailand may have acted as a wak up call for
international investors to reassess Indonesias macroeconomic performance.
Changes in International financial markets also facilitated the contagion effect. The IMFs first recommendation
during the Asian crisis was to shut down the operations of numerous financial institutions in Thailand and
Indonesia. 16 banks in Indonesia were closed in 1997 and another 7 in 1998. The IMFs recommendation to
close insolvent financial institutions, not realizing hat there was no depositors insurance, sent a signal to
investors and depositors elsewhere that there was not enough international support to protect their investments.
This resulted in a panic and bank run, which continued until January 1998, when Indonesian authorities
announced a depositor guarantee
The lost in investors confidence led to a sudden capital flight from the country which led its national currency,
rupiah to depreciate significantly against US dollars. The depreciation was soon followed by a national banking
crisis and ended up as a national economic crisis. Through the rupiah depreciation and higher interest rate (as
the monetary authoritys direct response in that time in order to stop capital flight), the crisis hit first middle and
high income groups such as current employees in the financial/ banking sector and large scale industries which
strongly dependent on credits from bank or other financial institutions and imports. After several months,
domestic inflation started to increase, and this accompanied with the increase in unemployment due to many
laid off employees in crisis-affected firms than resulted in a significant increase in the poverty rate in 1998.
Theoretical Impact of Currency Depreciation

10

Transmission Channels of the Effects of the 1997/98 Crisis on the Indonesian Economy.
Theoretically, the direct impact of a currency depreciation will be mainly on export and import of the particular
country (Figure 1). By assuming other factors constant, export, and hence, production and employment or
income in the exporting firms/sectors and in their backward as well as forward linked firms/sectors will
increase. This is the export effect of a currency depreciation. On the import side, domestic prices of imported
consumption and non-consumption goods will also increase. In the case of non-consumption goods, i.e. raw
materials, capital and intermediate goods, components/ spare parts, as a response to higher prices (in national
currency) of these imported goods, two scenarios are possible: (1) imports decline and, consequently, total
domestic production and employment also drop, or (2) imports may stay constant, but it means thus domestic
production cost will increase and finally it will result in higher domestic inflation. This is the import effect of a
currency depreciation.
Besides the above effects, a national currency depreciation also makes the value in national currency of foreign
debts (in foreign currency against which the national currency has depreciated) owned by domestic firms to rise.
Many highly foreign indebted domestic firms will face a serious financial crisis. If many of them have to reduce
their production or even collapse, domestic total production and employment will then further decline. This can
be called as the foreign debt cost effect of a national currency depreciation.
Indonesian Scenario
So, in this 1997/98 crisis case, the key transmission channels through which the crisis affected the Indonesian
economy were changes in export and import volumes and cost (in national currency) of foreign debts. With
respect to the impact on poverty, the next transmission channel were changes in employment/income, and
inflation.

11

When pressures on the Indonesian rupiah became too strong, the currency was set to float freely starting from
August 1997. Soon it began depreciating significantly. By 1st January 1998, the rupiah's nominal value was
only 30 percent of what it had been in June 1997. In the years prior to 1997 many private Indonesian companies
had obtained unhedged, short-term offshore loans in dollars, and this enormous private-sector debt turned out to
be a time bomb waiting to explode. The continuing depreciation of the rupiah only worsened the situation
drastically. Indonesian companies rushed to buy dollars, thus putting more downward pressure on the rupiah
and exacerbating the companies' debt situation. It was certain that Indonesian companies (including banks;
some of which were known to be very weak) would suffer huge losses. New foreign exchange supplies were
scarce as new loans for Indonesian companies were not granted by foreign creditors. As the government of
Indonesia was unable to cope with this crisis it decided to seek financial assistance from the International
Monetary Fund (IMF) in October 1997.
IMPACT OF CRISIS

Arrival of IMF
The IMF provided a bailout package totaling USD $43 billion to restore market confidence in the Indonesian
rupiah and demanded some fundamental financial reform measures: the closure of 16 privately-owned banks,
the winding down of food and energy subsidies, and it advised the Indonesian Central Bank (Bank Indonesia) to
raise interest rates. But this reform package turned out to be a failure. The closure of the 16 banks triggered a
run on other banks. Billions of rupiah were withdrawn from saving accounts, restricting the banks' ability to
lend and forcing the Central Bank to provide large credits to the remaining banks to avert a complete banking
crisis. Moreover, the IMF did not try to curb Suharto's system of patronage that was damaging the country's
economy and undermining the IMF accord. This patronage system was Suharto's tool to maintain power; in
exchange for political and financial support, he gave powerful positions to his family, friends and enemies.
Other developments that were negatively impacting on Indonesia towards the end of 1997 were a serious ElNino drought (causing forest fires and bad harvests) and increased speculation about Suharto's deteriorating
health (causing political uncertainties). Gradually, Indonesia was heading towards a political crisis.
A second agreement with the IMF was needed as the economy was continuing its downward spiral. In January
1998 the rupiah lost half of its value within the time-span of five days only, causing Indonesians to hoard food.
This second IMF agreement contained a detailed 50-point reform program, including provisions for a social
safety net, a gradual phasing out of certain public subsidies and the tackling of Suharto's patronage system by
ending monopolies of a number of his cronies. However, reluctance of Suharto to implement this structural
reform program faithfully, did not improved the situation.
A third agreement with the IMF was signed in April 1998. The Indonesian economy and social indicators were
still showing worrying signs. But this time, however, the IMF was more flexible in its demands than on
previous occasions. For instance, large food subsidies for low-income households were granted and the budget
deficit was allowed to widen. But the IMF also called for the privatization of state-owned companies, faster
action on bank restructuring, a new bankruptcy law and a new court to handle bankruptcy cases. It also insisted
on a closer monitoring of its implementation as recent experiences had shown that the Indonesian government
was not fully committed to the reform agenda.
Start of recovery

12

The removal of Suharto from presidency and new political system catalysed a fourth agreement with the IMF. It
was signed in June 1998 and allowed the budget deficit to widen further while new funds were pumped into the
economy. Within the timespan of a couple of months there were some signs of recovery. The rupiah began to
strengthen from mid-June 1998 (when it had fallen to 16,000 rupiah per dollar) to 8,000 rupiah per dollar in
October 1998, inflation eased drastically, the Jakarta stock exchange started to rise and non-oil exports started to
revive towards the end of the year. The banking sector (center of the crisis) remained fragile as the number of
non-performing loans were high and banks were very hesitant to loan money. Moreover, the banking sector had
caused a sharp increase in government debt as this debt was primarily due to the issuance of bank restructuring
bonds. But, albeit fragile, the country's economy improved gradually through 1999, partly due to an improving
international environment which caused a rise in export revenues.

Indonesian GDP and Inflation 1996-1998

Conclusion
Indonesia together with South Korea were among the most severely affected ones. The Indonesian economy had
plunged into a deep recession in 1998 with overall growth at minus 13.7 per cent. The crisis also led to a
significant drop in income per capita to drop, and a significant increase in poverty rate. There were three main
reasons why the rupiah depreciation had caused a serious decline in Indonesias aggregate output. First, despite
the fact that Indonesia has adopted import substitution strategy during the New Order era (1966-1998),
Indonesia, especially the manufacturing industry, has been increasingly dependent on imported capital and
intermediate goods, components and spare parts, and some processed raw materials. So, the rupiah depreciation
prevented many export-oriented firms from gaining better world price competitiveness, on one hand, while, on
the other hand, many domestic market-oriented firms had to close down or to cut their production volume
because they could not purchase any more very expensive imports. Second, many firms, especially
conglomerates, during the New Order era had borrowed a lot money from foreign capital markets; mostly were
short-term loans. They went bankrupt when rupiah depreciated and many other firms which had business
relations with them were also in trouble. Third, the national banking sector was also collapsed. By the end of
1997 16 commercial banks were closed, and access to credit became very difficult and interest rate increased
significantly. This has contributed significantly to output contractions in many sectors in Indonesia.

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Economic variables of Indonesia during crisis

SOUTH KOREA
THE CRISIS BEGINS

In November 1997, Korea was hit by a currency-cum-banking

crisis and an official assistance from the IMF helped them avoid a sovereign default. Let
us see how the crisis began in first place. In 1990, Koreas current account balance
started to deteriorate because of rising inflation, appreciation of the Korean won, and the
recession of the world economy. In order to finance the growing current account deficits,
the government encouraged capital inflows. In 1993, the Korean government also
announced a blueprint for financial sector liberalization that deregulated restrictions on
asset and liability management of financial institutions. This led to an increase in the
short-term foreign currency debts of financial institutions. Koreas external debt rose
from $89 billion in 1994 to $174 billion in 1997. The government by its policies
discouraged long-term foreign borrowing by business firms as it required detailed
disclosure on the uses of the funds as a condition for its permission. This incentivized
banks and business firms to finance long-term investments with short-term foreign
borrowings. These short-term external debts accounted for 61% of total external debts in
1996. There was proliferation of merchant banks owned by Chaebols, the South Korean
family owned conglomerates which were heavily engaged in borrowing cheap short-term
Japanese funds to finance mostly long-term investment projects. In order to stay in
business Commercial banks also borrowed from abroad at short-term maturities. The
mismatch problems stemmed significantly from weak prudential supervision. The
accounting and disclosure standards expected of financial institutions were below
international best practices, and market-value accounting was not widely practiced. Due
to weak financial supervision and high chaebol dependence on bank financing, risk was

14

concentrated on banks. In spite of all the risks associated with these mismatches, Korea
was still one of the worlds fastest growing economies with an average annual growth
rate of 7-9% and a modest inflation rate of about 5% a year for the three years leading
up to the crisis. The ratio of its foreign debt to GDP was less than 30%.
Given these situations, there were at three major developments that served as triggers
for the Korean financial crisis.
1. The movement of the US dollar: Most of the foreign borrowings were made on
the assumption that US dollar will stay weak thereby making Koreas exports more
competitive. The weakening of Japanese Yen against US Dollar made them recall
foreign loans putting a strain on foreign exchange reserve of Korea.
2. Bailout of ailing Chaebols by the government
3. Usage of foreign exchange reserves by Korean banks to service short
term debts.

HOW THE CRISIS WAS ADDRESSED?

The crisis in Korea was not a traditional balance of payment crisis due to
excessive external debt. It was a liquidity crisis which required a rapid infusion of hard
currency reserves. This happened due to serious mismatches in the currency and in the
capital structure in the balance sheets of the financial and non-financial sectors of the
economy. IMF promised disbursement of $58 billion over more than two years until 2000,
with each installment conditioned upon the progress Korea was to make in structural
reforms and the further tightening of its monetary and fiscal policies. Foreign banks
judged these amounts to be altogether inadequate, even in terms of meeting the
nations short-term obligations. Given the large amount of short-term obligations and the
precarious level of official foreign reserves, this judgment became a self-fulfilling
prophecy. As rollovers were refused, the limited foreign reserves were rapidly depleted.
Foreign creditors further accelerated the withdrawal of their funds from Korea, pushing
the country to the verge of a sovereign default in less than two weeks after the initial
agreement was signed. Korea was able to avoid this worst possible situation only with
the help of the United States.
In order to bring order back into the Korean economy, reforms were undertaken
to achieve two overriding goals: (1) to reduce the likelihood of a similar crisis in
the future by cleaning up the balance sheets of financial institutions and (2) to
evolve a financial system that can best help the nation resume growth with
stability. The reforms were primarily undertaken as (a) reforms designed to strengthen
the legal and regulatory infrastructure, (b) reforms implemented to rehabilitate the
financial sector, (c) reforms aiming at strengthening prudential regulation, (d) reforms to
reduce moral hazard, (e) reforms to strengthen the corporate governance of financial
institutions.

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a. Strengthening legal and regulatory infrastructure: The first step in

comprehensive financial-sector reform was laying out a statutory and regulatory
framework to implement necessary reforms. Thirteen financial bills, including a bill
to establish a consolidated financial supervisory authority, were enacted. The
Financial Supervisory Commission (FSC) was established and the existing separate
financial supervisory organs were merged into a consolidated Financial Supervisory
Service (FSS) to serve as an administrative body for the FSC
b. Rehabilitating financial institutions: Koreas banking sector had two major problems: inadequate
capitalization and poor-quality assets. This was due to the large number of chaebol bankruptcies that
damaged banks balance sheets carrying many non-performing loans. In order to address these problems,
the government had to step in with public funds. Loans with arrears more than 3 months were
constituted as Non-performing loans. Also policy regulations were carried out to control the functioning
of merchant banks.
c. Strengthening prudential regulations: Under the terms agreed with the IMF,
the Korean government strengthened prudential regulation by introducing a
forward-looking approach in asset classification, taking into account the future
performance of borrowers in addition to their track record in debt servicing. The
asset classification standards were further strengthened with the introduction of
the loans classification as non-performing when future risks are significant even if
interest payments have been made without a problem. Also, there were
regulations on short-term foreign borrowing by banks, strengthening limits on bank
lending to large borrowers, and strengthening disclosure requirements for financial
institutions.
d. Reducing moral hazard: The most significant institutional reform in this area was
the introduction of partial deposit insurance. Before the crisis, depositors and
investors had typically assumed that their assets were fully protected by the
government. Partial protection introduced market discipline by providing incentives
to depositors to seek out healthy institutions.
e. Strengthening corporate governance of financial institutions: In order to
strengthen the governance of financial institutions many measures have been
taken. They include allowing foreigners to own commercial banks improving
governance of financial institutions and strengthening the rights of commercial
bank minority shareholders, and raising the limit of bank ownership of domestic
residents from 4% to 10%.
As a result of extensive restructuring of the financial sector, many
insolvent or very weak institutions have been weeded out. In addition, both the capital
adequacy ratios and profitability of most of the nations financial institutions have greatly
improved.

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LESSONS FROM THE KOREAN CRISIS

1. Koreas decision to liberalize short-term capital flows ahead of long-term capital

flows was a serious mistake. Korea should have realized that short-term capital
flows are more volatile than long-term by liberalizing short-term before long-term
flows, Korea accumulated far too much short-term liability, which led o
uncontrollable mismatches in maturity and currency.
2. Superiority of a pure floating exchange rate system over a managed floating
system. Under a managed floating system, the market mechanism is hindered
from correcting trade or current account imbalances. In periods leading up to a fullfledged crisis, policymakers often fear that if they start making big adjustments, at
once the exchange rate will freefall, leading to a situation beyond their control
which encourage speculative attacks on the currency.
3. Need for prudential supervision and policymakers to regulate the economy.
4. To maintain the confidence of foreign investors, transparency on the business and government level is
critical.
5. Need to develop long-term capital markets in Korea. As long as long-term capital markets do not
develop locally in Asia, Asian countries are bound to suffer to some degree both maturity and currency
mismatches. The only way to eradicate this problem is to find ways and means to accelerate
development of capital markets in Asia and other emerging markets.

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