The East Asian Financial Crisis: Diagnosis, Remedies, Prospects

The East Asian Financial Crisis:
Diagnosis, Remedies, Prospects
Steven Radelet, Jeffrey D. Sachs, Richard N. Cooper,
and Barry P. Bosworth
Summary by: Daniel Coffman and Andrew Henkel
Emerging Market Crisis
• Crises often occur when economies that have
been on the receiving end of large capital
inflows stop receiving capital and instead face
creditors demanding repayment
• Sudden reversal of cash-flows often leads to
default on loans, rescheduling of payments, or
Self-Fulfilling Crises
• Individual creditors may act rationally, but
market outcomes lead to sudden reversals of
• Difference between illiquidity and insolvency
– Illiquidity: The borrower has the net worth to
repay all loans, but lacks quick access to ready
– Insolvency: The borrower does not have the net
worth to repay loans
• Even though the borrower may be solvent,
they may not be able to get new loans to meet
current debt obligations.
• Leads to liquidity crisis
• Root cause in international markets lies in the
bank’s tendency towards herd behavior
– Banks react to the activities of other banks instead
of individual debtor’s attributes
Domestic Markets
• Domestic capital markets are less prone to
self-fulfilling crises
• Advanced economies have mechanisms to
limit the onset of panics
• In the United States, we have the Federal
Reserve, which acts as the lender of last resort
in the event of a bank run
Was the East Asian Miracle A Mirage?
• The rapid growth seen in many East Asian
countries was real
• The rapid expansion of the financial industries
in many countries was not met with more
complete regulation and oversight
Response to the Crisis
• In this article, the response is divided into two
– Phase 1: August 1997 to December 24, 1997
– Phase 2: December 24, 1997 to April 1998
(publishing date)
Phase One
• Emergency lending agreements from the IMF
– Thailand- $17B
– Indonesia- $35B
– S. Korea- $57B
Loan Terms
• Loans to be made available in order to repay
debts and stabilize exchange rates
• Economic planning to include budget balance or
surplus, high nominal interest rates, and
restrictive domestic credit targeted at exchange
rate stability
• Financial sector restructuring to include closure
or suspension of several financial institutions and
increased oversight of financial institutions
Phase Two
• Dec. 24, 1997- U.S. Government decides to
press foreign commercial banks to roll over
Korean short-term debt credits
• Jan 28, 1998- $24B of Korean short-term debt
is converted to claims with maturities
between one and three years
• Korean Won stopped depreciating, and
decline of stock markets slowed in all three
crisis countries
• In Thailand, the government released a formal
guarantee of all outstanding private and public
liabilities to foreign creditors
• In Indonesia, previous loan agreements with
the IMF were intensified, followed by
announcements of de-facto suspension of
payments on short-term debt and the
guarantee of all commercial debt.
• Eventually these strategies worked and
currency depreciation slowed
• Radelet, Sachs, Cooper and Bosworth (1998),
“The East Asian Financial Crisis: Diagnosis,
Remedies, Prospects,” Brookings Papers on
Economic Activity, 1-90.
What Caused the Asian Currency
and Financial Crisis?
Giancarlo Corsetti, Paolo Pesenti,
Nouriel Roubini
Ha-Joon Chang
Two Views on the Causes
• One view: Sudden shifts in market
expectations—investor panic
– Explored in detail in the Radelet & Sachs paper
• Another view: Structural and policy distortions
in many Asian countries
Moral Hazard
• Moral hazard at three different levels
• Corporate:
– Tradition of public guarantees to private projects led to ignoring
costs and risks in project planning
– Governments frequently coerced domestic financial institutions
to make loans
– High capital inflows despite sustained poor returns
• Financial:
– Excessive borrowing from abroad and domestic lending by
national banks
– Many structural distortions ranging from lax supervision and
insufficient expertise to outright corruption
– Non-performing loans came to constitute upwards of 10% of
total lending on some countries
Moral Hazard
• International:
– Substantial lending by international banks with little
concern for risk assessment
– Expectation of bailouts—“too big to fail”
– Sustained economic stagnation in Japan affected trade
balances by causing a slowdown in export growth
– Appreciation of US dollar hurt cost-competitiveness
– Competitive pressures increased due to China’s rising
export economy
– Reserves of foreign currency were insufficient in
several countries to cover external obligations in the
event of a liquidity crisis
Macroeconomic Fundamentals
• The countries hit hardest by the crisis had all
been running substantial current account deficits
throughout the 1990s—as high as 10% of GDP
– Other economies in the region such as Singapore,
Hong Kong or Taiwan were running current account
• These countries also all had large foreign debt to
GDP ratios
• High rates of growth in the area that proved to be
unsustainable were incorrectly projected into the
future, promoting large capital inflows
Macroeconomic Fundamentals
• Investment efficiency was already falling in
Asia even before the crisis
– Most of the largest Korean chaebols had a return
lower than their cost of capital
• Political instability, such as that in Thailand
and Indonesia, created additional market
Distress in 1997
• Thailand: Even before the crisis, a large number of Thai
financial institutions were effectively bankrupt
– Thailand ultimately had some 56 financial institutions go
bankrupt after the government abandoned plans to bail
out its finance sector in favor of trying to save the baht
• Korea: The crisis was preceded by several bankruptcies
among the chaebols in early 1997
– This led to a shocking drop in industrial growth and greatly
affected the financial sector, which had borrowed abroad
and loaned to many of the bankrupt companies
Distress in 1997
• Malaysia: The central bank’s delayed response
to a real estate bubble sparked a stock market
crash in early 1997
– The Malaysian stock market continued to decline
throughout the crisis
• Japan: In 1997, an apparent recovery in the
leading regional economy was wiped out by
yet another recession
Currency Crises
• Speculation attacks were launched against many currencies
in the region, which had been pegged to the dollar
– First was the Thai baht, which was allowed to float in July
– Malaysia, Indonesia and the Philippines were all subsequently
• Over the course of 1997, the values of these four currencies
dropped precipitously by between 25% and 45% of their
prior value
• Speculation also was brought against Singapore, Taiwan,
Hong Kong and Korea
– The first three countries only suffered moderate depreciation,
but the won ultimately dropped in value by almost half—25% in
November 1997 alone
Effectiveness of the IMF Response
• The IMF-prescribed high interest rates may have
contributed to the 1998 recessions by being
sustained too long
• The IMF’s handling of insolvent banks may have
resulted in destabilization of otherwise healthy
banks elsewhere in the region
• IMF disbursements may have increased moral
hazard issues on a global scale, though evidence
suggests that not issuing this type of
disbursement in a crisis likely has worse results
than those created by moral hazard
Global Effects
• In 1998, the East Asian crisis spread to international
• Hong Kong, Singapore, the Philippines and Taiwan all
experienced recessions
• Japan’s recession worsened
• Commodities prices fell sharply, affecting Latin America
• A severe economic crisis hit Russia following the
collapse of its currency and threatened to affect US
capital markets
• Despite fears of a global recession, investor confidence
improved near the end of the year, likely due to
concerted US and international actions
• Chang, H-J. (2000), “The Hazard of Moral
Hazard: Untangling the Asian Crisis,” World
Development 28 no. 4, 775-788.
• Corsetti, Pesanti and Roubini (1999), “What
caused the Asian currency and financial
crisis?” Japan and the World Economy 11, 305373.

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