What caused the currency and financial crisis in Asian economies ?

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What caused the currency and financial crisis in Asian economies ?

The 1997-1998 financial crisis in Asia is the sharpest to hit the developing world since the debt crisis in 1982.This period highlights the main weaknesses in international capital markets and shows how vulnerable they can be to sudden reversals in market confidence. Many point to the change in market expectations and confidence as the source of the problem while others blame the fundamental imbalances in these Asian economies. Whichever view, it is no doubt that the panic and overreaction of investors, the questionable policy response of the International Monetary Fund {IMF} and policy mistakes made by Asian governments are all factors which only deepened the crisis. In this essay we examine the Asian meltdown and provide reasons for why stricter controls on international capital flows were needed. The countries hit hardest by the Asian crisis were Indonesia, Korea, Thailand, Philippines and Malaysia, known as the Asian five. Our discussion centers mainly on these countries.

Our examination of this crisis begins with the liberalisation of financial markets in the early 1990’s. Amid political pressure to maintain high levels of economic growth, the banking and financial systems became deregulated. As a result, domestic banks offered higher rates of return to foreign investors, attracting huge financial inflows, as investors were only too keen to pour their money into these countries. Huge loans were being taken on for domestic investment at the cost of large and persistent current account deficits. Domestic banks were taking massive loans from abroad and lending recklessly to domestic firms who invested in unprofitable and risky areas.

The problem of misplaced investment was particularly evident in Korea and Thailand, where there was over-investment and over-capacity in the non-traded sector. A lot of funds were used to finance the building of multi-storey offices and luxury hotels. Over investment in this sector led to over-capacity, where in many hotels the room occupancy rate was typically 20% or less of capacity. This risky investment yielded very low rates of return which were way below expectation. Misplacement of investment was evident in Korea with the dominance large firms called conglomerates {“chaebols” in Korean} over domestic banks. Because these giant firms had a large, if not a majority share in domestic banks, obtaining loans on request was easy. This heavy borrowing to finance risky investments led to at least 7 of the top 30 conglomerates being effectively bankrupt in 1997, triggering the financial crisis.

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To maintain large inflows of funds from abroad, Asian countries tied their exchange rate on a one-to-one basis with the U.S dollar. The objective of this was to reduce the risk premium on dollar denominated debt, making the cost of borrowing cheaper, and also to achieve stability and credibility. Initial reasons for this exchange rate policy were mainly for high investment rates and high levels of productivity and output. This exchange rate policy backfired for Asian countries when a rise in interest rates caused the value of the dollar to soar after mid-1995.

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