What caused the Asian Financial crisis

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What caused the Asian Financial crisis?
Thu Thi Hoang Macroeconomic weaknesses John
Parker Financial intermediaries The Bubble
Mark Steingraeber

Bernard Villanueava
Brian Ikihara
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Asian financial crisis overview
The Asian financial crisis is considered to have
started on July 2, 1997 with the devaluation of
the Thai baht and ask IMF for assistance.
Malaysia abandons the peg and blames the
speculators on July 14 Philippines seek
assistance form IMF
Indonesia floats on August 14, go to the IMF on
October 8
Repeated speculative attacks on Hong Kong dollar
unsuccessful, but stock market plunges between
October 20-23
Global stock market decline on October 27
S. Korea devalue Nov. 28 and ask for IMF
assistance
Spread over other Asia countries
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Macroeconomic weaknesses

• Large current account deficit

• Large capital inflows

• Large exchange rate depreciations

• Bank lending

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Current account deficits
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Large capital inflows

• Large capital inflows, especially those deriving
  from foreign borrowing.
• These inflows equivalent 1990-1996
• Korea 2.5 of GDP
• Thailand 10
• Indonesia 3.5

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Large capital inflows

• They were encouraged by high economic growth, low
  inflation and relatively healthy fiscal
  performance (table1 and figure 2)

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Large exchange rate depreciation (to the US
Dollar) Period averageSource International
Financial Statistics ( IMF)
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Large exchange rate depreciations (cont.)

• Inflexible exchange rate regimes complicated
  macroeconomic management and increased
  vulnerability.
• Nominal exchange rate had depreciated in a
  predictable manner in Indonesia, and was closely
  linked to the U.S in Malaysia, the Philippines
  and Thailand.
• The crisis countries were vulnerable to capital
  outflows and exchange rate devaluations because
  of the significant amount of short term foreign
  currency debt, which was mostly unhedged.

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Bank lending

• Private credit sector in nominal terms expanded
  rapidly during the 1990s, at an average rate of
  15 to 20 compared to inflation rates of 3-10.

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Bank lending (cont.)

• Bank lending relied collateral rather than credit
  assessment and cash flow analysis, making banks
  vulnerable to excessive risk and declines in
  asset values.

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What caused the Asian Financial Crisis Part II
Two conventional models.
The First Generation crisis model (Krugman
1979 Flood and Garber 1984) describes a
government with persistent money financed budget
deficits that uses its limited reserves to peg
its exchange rate. This will of course be
ultimately unsustainable. At some point a
speculative attack will occur when investors
believe collapse is imminent.
The Second Generation crisis model (Obstfeld
1994, 1995) describes a government making a
tradeoff between short-run macroeconomic
flexibility and longer- term credibility. In
this model higher interest rates are required to
defend parity if the market defense of the peg
will ultimately fail. A speculative attack can
develop either as a result of an expected future
failure or as a self-fulfilling prophecy.
As useful as these two models have been
describing most historical currency crisis they
fail to explain the AFC.
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First, none of the governments were engaged in
irresponsible monetary expansion, in fact their
inflation rates were quite low. On the eve of
the crisis all of the governments were more or
less in fiscal balance.
Second, the Asian countries did not have a
troubling level of unemployment. Therefore there
did not seem to be any pressure to abandon the
fixed exchange rate in favor of monetary
expansion.
Third, there was already a boom bust cycle in
the asset markets that preceded the currency
crisis.
Fourth, in all countries involved in the AFC,
financial intermediaries seem to have been
central players in the crisis. In Thailand so
called finance companies nonbank
intermediaries that borrowed short-term money
then lent to speculative investors played a
crucial role.
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What are Financial Intermediaries and what role
did they play in the crisis?
financial intermediaries were institutions
perceived as having implicit government
guarantees but were in most part unregulated and
subject to sever moral hazard problems
Unrestrained risky lending by these institutions
caused inflation of asset prices (but not
consumer goods). This over pricing of assets was
sustained by a sort of circular process of
reinforcement. The proliferation of risky
lending drove up asset prices making the
collateral position of the lending institutions
seem stronger than it actually was. Also, the
appearance of soundness of the position of
financial institutions further increased risky
loans putting even more upward pressure on asset
prices.
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Then the bubble burst!
The reverse of the upward spiral occurred with a
vengeance. Falling asset prices quickly made
financial institutions insolvent forcing them to
cease lending which led to a further acceleration
of asset depreciation. This reinforcing circular
decline can explain the contagious nature of the
crisis to countries without visible economic
links. Other countries where the asset bubble
had not yet burst suffered a decline of investor
confidence because of the suddenness, severity
and unpredictableness of the Thai crises which in
turn led to self fulfillment of the crisis in
that country. The loss of investor confidence
caused a decline in asset prices which then
followed the reinforcing downward spiral of asset
prices and collapse of financial intermediaries
as in Thailand.
Although the moral hazard/asset bubble view is
not the full story of the cause of the crises, it
is surely a leading contender as a primary cause.
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How do we resolve baffling nature of the AFC
The problem was off the government balance sheet.
The fact that government guarantees of the
financial institutions was at best implicit, made
these liabilities invisible until after the fact.
Even the implicit guarantees of the US SLs in
the 1980s was not a visible government liability
until they actually failed.
The boom and bust cycles of the asset market
preceded the currency crisis because the
financial crisis was the real cause of the whole
process with currency fluctuations a result
rather than a cause of the AFC.
The AFC was able to spread without specific
exogenous shock to other Asian economies because
of vulnerability to self-fulfilling pessimism
which generated a downward spiral of asset
deflation and disappearance of a financial
intermediation structure.