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What were the main causes of the East Asian financial crisis?

Extracts from this essay...

Introduction

MSc Development Studies 2003/4 Module: Images of Development What were the main causes of the East Asian financial crisis? The East Asian financial crisis of 1997 represented a major interruption in the rapid economic and social development enjoyed by much of the region in the decades leading up to it. In less than a year, some East Asian economies went from being examples of successful development practice to a situation of economic stagnation and decline. Growth rates that had averaged 8-10 per cent per year over many years turned negative, economies that enjoyed continuous high employment and experienced labour shortages suffered from rapidly rising unemployment levels, and stock market assets lost half their value. In a region where growth was dubbed 'miraculous', economies became structurally unstable and needed rapid intervention by international agencies such as the IMF (UNCTAD, 1998). The crisis arose from the large scale shift of funds out of domestic financial markets in the region, starting in Thailand (IMF, 1997). The effects of the financial crisis are still having an impact not only in the region but are also reverberating around many other parts of the global economy. This essay first attempts to define 'East Asia' by reviewing the different sets of countries in literature focussing on the crisis. It outlines the countries that suffered most as a result of the crisis, by examining pertinent economic and financial indicators in the region. It asserts that a discussion of the causes of the crisis is impossible without an understanding of the development process in the region before crisis, and examines the particular circumstances in the region that may have contributed to the onset financial crisis. It then looks at the context for the financial crisis and focuses on events in Thailand - the country where the crisis first took hold - in an attempt to identify the relative importance of the various underlying causes of the crisis put forward.

Middle

Since many economies in the region were pegged to the Dollar, the competitiveness of their exports rose, encouraging still further influx of capital into the region. In 1995 the Dollar had reached its lowest level against the Yen and in response to warnings that this could trigger sell-offs of Japanese holdings of US Treasury Bonds, the Dollar was pushed up. When the Dollar gained in strength from 1995, this favourable condition in the region was reversed, leaving economies with losses in competitiveness and a reduction in export growth. In the region as a whole, export growth rates fell from an average of 20 per cent per year in the mid-1990s to only 5 per cent in 1996. The clear correlation between the relative strengths of the Dollar and Yen and the health of East Asian economies brought into question with wisdom of maintaining pegged exchange rates between a relatively small country's currency to the world's most powerful economy, as it exacerbated any problems the region already had. This phenomenon is discussed below. In addition to the part played by Japan and the US, Beams (1998) points to the role of China as an external factor that contributed to the build up to the East Asian financial crisis. The 50 per cent devaluation of China's currency in 1994 made its exports increasingly competitive: China already boasted cheaper labour than many of the East Asian economies where massive growth had fuelled rises in the costs of living and therefore wage rises. Investment began to move on from East Asia to China from 1994 onwards, putting further pressure on other East Asian economies by providing a certain amount of new competition in addition to diverting investment. As each individual country's economic growth slowed, they were also less able to export commodities to each other. Part of the success of development of manufacturing in the region was based on the ability of countries to trade intra-regionally, often engaging in 'work-sharing' which meant that countries engaged in different sectors

Conclusion

Some economists, such as Beams (1998), asserted that the theories outlined above merely describe the symptoms of an over-expansion and subsequent contraction of the market - the so called 'boom and bust' cycles that are an intrinsic part of the capitalist economy - rather than explaining the causes of the crisis. In saying this Beams seems to blame the international capitalist economy itself rather than any of the factors discussed above that were pertinent to the East Asian crisis. It is certainly true that the crisis in East Asia exhibited many of the same characteristics as other crises in Mexico, Brazil and Russia. They were all emerging markets that enjoyed an influx of foreign capital previous to crisis, enabled through financial liberalisation. The crises were precipitated by currency instability coupled with a loss of investor confidence and contagion. But while the relevance of this assertion is undeniable, it fails to explain the particular set of circumstances and the nature of the pattern of events that was particular to East Asia. It is clear from this analysis that the East Asian financial crisis was caused by a combination of inter-relating factors. These were both underlying conditions - leaving economies in a fragile situation even if growth was strong - and chains of events that actually brought about the crisis. The most important underlying factors were financial fragility due to the large percentage of short-term investments; mismanagement of incoming funds by domestic financial institutions that were unprepared for the scale of investment and tended to give loans to low quality enterprises; external change that undermined comparative advantages and altered the inter-regional balances; and currency inflexibility that caused pressure of local currencies when the Dollar and Yen appreciated or depreciated. Although these were the underlying causes setting the right conditions to crisis, it is evident that the most important factors in actually bringing about and spreading the crisis were currency depreciation and contagion.

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