The Asian Financial Crisis — A Comparative Analysis of Policy Responses
by Ong Jing Yee and Tan Yong Qi
From 1965 to 1990, the Asian economies experienced rapid export-led growth — Southeast Asian countries in particular experienced a 2–9% average growth in annual real GDP (Summers and Heston, 1991). At the time, most of these countries had their currencies pegged to the USD to prevent price fluctuations and remain competitive in the international export market. As a result, Asia’s share of world manufactured exports surged from 9% in 1965 to a historic high of 21% in 1990 (IMF, 1994). Simultaneously, there were economic slowdowns in Europe and the USA. With interest rates lower in these regions, many foreign investors were interested in Asia, further boosting Asian economic growth.
However, most of these inflows were hot money flows (a form of short-term investment, where investors move their money between financial markets to make profits from high interest rates) into the country’s financial system. These short-term investments were then used to finance factor accumulation (increasing capital and labour) to increase production in the short run, rather than on developing technological or human resources to enhance the efficiency of the production process (Krugman, 1994). Furthermore, a significant portion of the FDIs was channelled into the property and housing market, leading to overheating in these markets and the prevalence of asset bubbles because of the unrealistic overvaluation of stocks and properties (Guide, 2021).
On the other hand, many Asian banks started to profit by borrowing short-term overseas foreign currency and re-lending the funds locally at 4–6% higher interest rates. These Asian banks also participated in pawnshop lending, where the destination of loan funds was not prioritized as long as borrowers provided sufficient security or collateral to cover both principal and interest. This led to a sharp rise in non-performing loans as lower quality borrowers defaulted on their loans. Similarly, domestic investors were exposed to the overseas markets when they borrowed abroad because of lower interest rates. The increasing level of external debt within Asia had caused higher levels of indebtedness (Cabral, 2010).
In 1994-5, to control inflation, the US raised its short term interest rate by 3% following economic recovery (Weller, 2002). This caused an outflow of hot money from Asia to the US. As more investors were buying USD to invest in the US, the dollar appreciated, causing exports for countries with pegged exchange rates to be less competitive internationally (Somanath, 2011). With an elevated level of foreign capital outflows and plummeting export growth, Asian economies were pressured to depreciate their currencies.
The Asian Financial Crisis (AFC) started to build up when foreign investors started a speculative attack on Thai’s Baht. The Thai government ran out of USD reserves on 2 July 1997 to maintain the USD peg, forcing them to float the Baht, inducing an immediate sharp devaluation of Baht (Sharma, 1998). Due to contagion, the Baht crisis resulted in a loss of confidence for similar Asian economies. More and more foreign investors started to reassess investments into the Asian economies as relatively risky, causing further rounds of capital outflows from Asia, spreading the currency crisis to other countries such as Singapore, Malaysia, the Philippines and Indonesia. As a result, affected countries saw a drastic devaluation in their currencies after being forced to abandon their peg to USD due to the drying up of foreign reserves (Cheetham, 1998).
Governments now faced a dilemma — whether or not to accept IMF aid. Countries that eventually received IMF funds were Thailand, Indonesia and South Korea, while those that refused were Malaysia and the Philippines. This article will focus on 2 countries, one that accepted IMF assistance — Thailand — and Malaysia, which chose the path of recovery under the leadership of the country.
Thailand and IMF assistance
On 2 July 1998, after Thailand’s international reserves were exhausted, the large-scale foreign borrowing exacerbated the financial meltdown in Thailand, as non-bank companies in the private sector had USD63 billion of debt by the end of 1996 and USD29.2 billion was due in less than a year, triggering a downward spiral of asset deflation and disintermediation (Doner and Ramsay, 1999). This series of events prompted the Bank of Thailand (BoT) to accept the IMF’s package amounting to USD17.2 billion over a 34-month period (IMF, 2000).
This came with a condition of austerity — the Thai government cut spending on infrastructure projects with low economic returns, subsidies on utilities and petroleum products by 100 billion Baht, reducing their current account deficit from 8% to 3% of GDP in 1998 (The Washington Post, 1997). The BoT also increased interest rates to keep export prices low, boosting competitiveness to control currency depreciation. Furthermore, structural reform of the financial sector was emphasised with immediate shutting down of non-viable institutions and the mandatory introduction of Basel capital adequacy standards and internationally accepted accounting practices. The Financial Sector Restructuring Authority was set up to inspect the debt restructuring processes and liquidation of 58 non-viable finance and credit companies, in which their operations were suspended to avert further losses (Head, 2009). As a result, 56 out of 58 insolvent institutions which borrowed about USD16 billion from BoT were shut down and the government was not allowed to bail-out any local institutions.
Thailand’s economy recovered to positive growth in late 1998. GDP growth reached over 4.2%, with an improvement of export market performance and a gradual recovery in domestic demand, stimulated by the government’s fiscal measures.
Exports volume recorded a slight increase from 6.7% to 8.9%, but net income from the export of goods and services decreased, as import growth exceeded exports. The revival of businesses that were suspended increased imports of raw materials and intermediate goods for the production of exports and fulfilled domestic demand. Regardless, the balance of payments became far healthier, registering a surplus in 1999 as a consequence of the increase in exports and FDI as well as capital inflows to the public sector.
However, the balance of payments and current account decreased relative to the previous year, 1998, which was due to declining external debt. In 1999, the Thailand government repaid the external debts of Bangkok International Banking Facilities (BIBF), successfully reducing total outstanding debt from USD86.2 billion to USD75.6 billion. International reserves also stood at a secured level (USD34.8 billion). Combined with output recovering to appropriate levels, Thailand authorities received no further disbursement from the IMF after September 1999 (Bank of Thailand, 1999).
The financial system became more prudent — the BoT initiated a new draft of financial law in 1999, to create greater unity in the regulations of financial institutions. This promoted transparency to enhance the resolutions dealing with systemic risk. In 2002, BoT was involved in the promulgation of 7 banking and financial laws which laid the fundamentals to financial strength that played a crucial role during the global financial crisis (Bank of Thailand, 2002). Financial institutions were more provident in expanding balance sheets, which were now limited by capital size rather than the availability of funds.
Malaysia’s Road to Recovery
In 1997, Malaysia’s ringgit depreciated by 45% against USD with a total net outflow of US$ 11 billion in foreign funds due to the contagion effects from the devaluation of Baht in 1997 (Cheetham, 1998). In the same year, the massive capital outflows evaporated almost $225 billion of share values from Malaysia’s stock market, causing the Kuala Lumpur Stock Exchange (KLSE) index to fall by 50%. Consequently, the falling amount of FDI indicated that there was decreased input into the production of goods and services in Malaysia, leading to a reduction in GDP by 6.8% in the second quarter of 1998. With the economic downturn, many businesses in Malaysia were making losses and facing bankruptcy, forcing them to cut costs by making employees redundant or by closing their business. As a result, the number of retrenchments in domestic manufacturing jumped from 19,000 in 1997 to over 83,000 in 1998, accounting for a rise of 1.3% in the unemployment rate (Athukorala, 2010). With rising unemployment, many borrowers in Malaysia who lost their jobs were no longer able to repay their loans, leading to an almost 12% increase in non-performing loans by July 1998 (Athukorala, 2003).
In the 90s, Malaysia implemented the New Economic Policy (NEP), aimed at redistributing wealth through affirmative action in the aftermath of the racial riot in 1969 (Aznam, 2005). The IMF’s request to open up Malaysia’s economy as a condition of their assistance conflicted with the NEP. For instance, under the IMF’s requirement, Malaysia might need to abolish the imposed limit of foreign ownership in Malaysia’s companies, which would have possibly decreased local company ownership, slashing the effectiveness of NEP. In comparison to other affected countries in AFC, Malaysia also found itself with relatively stronger macroeconomic conditions — lower external debt, lower inflation and most importantly, a significant fiscal surplus pre-crisis. Therefore, Malaysia chose the path of rejecting IMF assistance.
Similar to IMF approaches, the Malaysian government started their AFC rescue plan through macroeconomic contraction but with a stronger emphasis on capital controls. On 31 August 1998, Malaysia decided to ban offshore trading of Malaysian companies’ shares, followed by strict short-term capital controls including the imposition of a 12-month withholding period on repatriation of portfolio proceeds. Additionally, a peg of RM3.80 per USD was announced on 2 September 1998. These policies minimised the amount of capital flight from Malaysia to avoid speculative hedge funds from driving down the value of the ringgit. Moreover, by refraining short-term funds from leaving Malaysia, the government was able to reduce the amount of foreign reserves needed to defend the dollar peg, stabilising the value of the ringgit to restore investors’ confidence. Furthermore, the Malaysian Central Bank raised the policy interest rate to a historic high of 11% in February 1998 to attract foreign investments, ensuring adequate reserves in defending the peg.
This led to signs of economic recovery for Malaysia. GDP growth rate increased from -7.4% (1998) to a positive growth rate of 4.1% in 1999. There was also growing business confidence as the market capitalisation of the KLSE rebounded from a record-low of RM 200 billion in 1998 to over RM 700 billion in 2000. Therefore, the second stage of Malaysia’s AFC rescue package focused on restructuring the banking and corporate sector as well as financing fiscal and monetary stimulants by issuing securities.
Conclusion
When the global financial crisis happened in 2008, the countries affected by the Asian Financial Crisis were able to make adjustments that acted as buffers to the possible contagion of the global financial crisis. The comprehensive reforms introduced post-AFC laid a foundation for more effective uses of macro and microprudential measures and a better policy framework — the countries were in a much stronger position during the global financial crisis, even allowing them to maintain growth in a less favourable economic climate. Despite that, the countries in the region remain vigilant to any fluctuations in the economies, in hopes of being able to manage future negative macroeconomic complications from potential risks.
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