Also known as the Asian Contagion, the Asian Financial crisis of 1997 started in Thailand as the country allowed its currency to float freely in the market. The devaluation of the Thai baht destabilised Thailand, with the effects spilling over to neighbouring East Asian countries and the entire global financial markets. The financial crisis particularly had devastating effects in Thailand, Indonesia, and South Korea; and it took the intervention of the IMF (International Monetary Fund), World Bank, and the US Federal Reserve Bank to prevent a looming economic collapse and to restore confidence in the financial systems of the affected countries.
The largest economies that were part of the Association of Southeast Asian Nations (ASEAN) witnessed high levels of growth during the 1980s through to the mid-1990s. For instance, Thailand averaged economic growth of 9% from 1985 to 1996. The Asian Tigers (as they were referred to) had seen their export-led economies benefit from huge capital inflows as well as favourable exchange rates. Their high-interest rates attracted foreign capital, while a US-led agreement in the mid-1980s had helped to make their exports attractive in international markets.
In 1985, G5 nations had signed the Plaza Accord that sought to help the US to reduce its trade imbalance. This saw the US dollar devalue relative to the currencies of other G5 nations. Most of the Asian Tigers pegged their currencies to the US dollar, which consequently weakened their currencies and effectively increased the attractiveness of their exports. But in the early 1990s, the Plaza Accord had arguably served its purpose, and the US then started implementing a different monetary and fiscal policy that would help the country curb inflation.
This led to a stronger US dollar, and the inevitable appreciation of the local currencies of the Asian Tigers as they were pegged to the US dollar. With the US in an environment of higher interest rates, capital inflows to the East Asian countries diminished gradually, while their exports also began to lose competitiveness in international markets owing to their stronger local currencies. The Asian economies were still growing at astonishing rates, but there were now real underlying concerns or threats.
How the Asian Financial Crisis Unfolded?
Thailand was a fledgling economy throughout the 1980s and early 1990s before the country experienced a speculative attack on its local currency in May 1997. Keen to maintain its US peg, the country tried to defend the value of the Thai baht. But limited foreign currency reserves meant that the resulting efforts were futile, and Thailand finally succumbed to the pressure of devaluing the Thai baht, removing the peg in July 1997 and allowing it to float freely in the market. The Thai baht was initially pegged at 25 to the dollar, but by January 1998, it had depreciated to 56 to the dollar.
The Thai economy experienced an instant shock and numerous companies collapsed, including Finance One, then Thailand’s largest finance company. The country experienced a credit crunch and most corporations could not continue their huge capital investment plans. The Thai stock market lost over 75% of its value and unemployment rates increased sharply.
The economic shocks in Thailand soon reverberated throughout Asia and beyond. In neighbouring Indonesia, the Thailand US-peg removal prompted the country to widen the trading band of its local currency. This, however, encouraged a speculative attack on the Indonesian rupiah, which tumbled to 11,000 to the dollar by January 1998 compared to the pre-crisis exchange rate of about 2,500 to the dollar. The financial crisis in the country saw major world sporting events, which were scheduled to be staged in the country, cancelled, and the chair of the central bank was also sacked. The biggest casualty at the time was President Suharto who was forced to resign due to public pressure.
In South Korea, the crisis could not have come at a worse time. Its companies were taking in so much debt in a bid to compete on the world stage, plus a corruption scandal at a major steel company raised investor concerns. Credit rating agency Moody’s also downgraded its ratings for the country twice in two weeks during the last quarter of 1997. Stocks that were already in a bear market plunged further and major corporations failed or were taken over. The South Korean Won lost almost half its value, and the nation itself saw its debt-to-GDP ratio double during the crisis.
The impact of the crisis would, however, go beyond these 3 countries and it spread into other Asian nations such as the Philippines, Malaysia, China, Japan, Singapore, and Mongolia. The crisis also inspired panic among investors in South America and the United States. Away from economic shocks, there were also political and social consequences. Top Thailand and Indonesian leaders were forced to resign and there was a focus on the negative impact of crony capitalism. There was also much emphasis placed on improving both corporate and national governance. Other developing nations around the world were also affected, as investors zipped up their wallets viewing them as risky destinations.
The Aftermath of the 1997 Asian Financial Crisis
In response to the crisis, the IMF mobilised over $110 billion in short-term loans to the most affected nations to stabilise their economies, rebuild their foreign reserves, and to repair relationships with foreign creditors. The loans also came with some strings attached. That is, the countries had to perform some structural reforms: tighten their fiscal policies, strengthen their financial systems, hike their interest rates to stabilise their currencies, as well as improve the flexibility and competitiveness of their economies.
The funds to stem the crisis were pooled from the IMF, World Bank, the Asian Development Bank, as well as governments from Europe, the Asia-Pacific region, and the United States. The US Federal Reserve bank, in particular, played a major role; the central bank encouraged US commercial banks to offer flexible conditions to loans advanced to South Korean banks and companies, and also arranged special US credit opportunities for Thailand. The coordinated international efforts, combined with domestic adjustments of the affected nations, ensured that the Asian crisis was dealt with effectively. The affected nations soon found their footing again and went on to post impressive economic recoveries and further growth expansion.
By 2001, most nations had recovered from the effects of the crisis. Thailand managed to pay all its IMF debt as early as 2003, 4 years ahead of schedule. As early as 1999, the Indonesian economy had started recovering and the new political order maintained a working relationship with the IMF. Indonesia also continued to expand its political space and has continually transitioned into a modern democracy. On its part, South Korea recovered quickly and went on to build an incredibly diversified economy that is vibrant to date.
The 1997 Asian financial crisis crucially highlighted the danger of holding huge debt in foreign currencies. The ASEAN nations saw their debt obligations rise as the US dollar (the currency they pegged their local currencies to) strengthened. Most of these debts were accumulated by major corporations and their inability to pay them back helped catalyse the crisis.
Another important lesson to draw from the crisis is the danger of pegging a local currency. Most Asian nations during the time pegged their local currencies to the US dollar, and in times of crisis, they would be forced to use their limited foreign reserves. Pegging local currencies to the US dollar helped attract investors who desired foreign exchange rate stability, but over time, it also left the countries vulnerable.
The Asian crisis also demonstrated the herd behavior of financial markets that can accelerate panic. Capital inflows literally dried up as countries tried to implement various measures to curb the financial crisis. This eventually led to a credit crunch which ultimately made the events a self-fulfilling prophecy.
There is also proof that several policy adjustments have been made to prevent a recurrence of the 1997 crisis. Most East Asian countries have now built up huge foreign currency reserves, which makes them more likely to deliver impactful interventions during crisis situations. Domestic borrowing as well as borrowing in their local currencies has also been promoted, while capital inflows are now being monitored proactively and controlled better. Governments and corporations in the region have also been encouraged to take up more equity finance which is less risky and more stable, as opposed to the risky and unpredictable debt financing options.
The Asian financial crisis of 1997 illustrated how globally interconnected economies have become in this age. The crisis, triggered by a currency devaluation, wreaked havoc within and externally. It displayed the importance of assessing foreign exchange risk as well as corporate borrowing. Most affected nations have now dramatically modernised and diversified their economies. They have also created fundamentally sound economic policies and structures to enhance financial stability and flexibility. Every crisis comes with some lessons, and clearly the ones served by the 1997 Asian crisis have been largely heeded.