Asian Financial crises
Chapter

Chapter 45 An Analysis of Financial Crisis

Author(s):
International Monetary Fund
Published Date:
January 2001
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Abstract:

Adverse shift in investors’ confidence in Asia was associated with weak fundamentals, particularly those pertaining to the external and financial sectors. Lessons from the crisis include strengthening those fundamentals, creating a large liquidity fund, and designing loss-sharing arrangements involving private lenders and borrowers.

The Asian financial crisis, beginning with the collapse of the Thai currency in July 1997 has generated much discussion worldwide. The SEACEN Seminar on Financial Crisis in the Asian Region held in Kuala Lumpur on June 23–25, 1998 marked an occasion for policy makers from the affected countries to put forth their views, share their experiences and insights as well as update one another on latest developments. The experiences of Indonesia, Korea, Malaysia, Philippines, Taiwan, and Thailand were thoroughly discussed.

1. OVERVIEW OF THE CRISIS

A common conclusion was that the cause of the crisis cannot be pinned down to just a few factors. There were “trigger” and “augmenting” factors. The most important trigger factor was the shift in investors’ confidence after a build-up of massive short-term capital inflows to finance current account deficits. The sudden and drastic slowdown of exports in 1996 was mainly responsible for this shift in investors’ sentiment, leading to capital flight and a free fall of currencies. The augmenting factors included, among others, structural weaknesses and inappropriate macroeconomic policies such as a rigid nominal exchange rate policy, a weak regulatory and supervisory framework, and a fragile financial system. These problems were compounded by ineffective handling of short-term capital inflows, which were invested mainly in the property and share markets. Another important augmenting factor was the contagion effect that fanned the crisis quickly across the region, even to countries seemingly not related to the origin of the crisis. To some extent, the different effects of the crisis on the individual countries reflected the respective country’s resilience owing to its economic structure, sociopolitical factors and ability to manage the crisis.

To the Asian policymakers, the crisis was viewed as a result of collective actions of many parties—the private sector, policymakers, international investors, hedge funds, international rating agencies, and multilateral institutions. Although foreign investors ignited capital flight, fanned by domestic investors, the real panic began only when domestic investors moved capital out of the country after the crisis “threshold” was reached. Given the large resources that hedge funds commanded and their profit-maximizing objective, hedge funds also contributed to the crisis as can be observed from the patterns and sizes of their transactions during the height of the crisis.

2. LESSONS FOR THE INTERNATIONAL FINANCIAL SYSTEM

  • The crisis has underscored the urgent need to overhaul the international financial system that had not kept pace with financial markets’ rapid development and progress. In this respect, the following issues were emphasized: moral hazard of international rescue operations; prudential standards and incentives for compliance; greater transparency and disclosures; role of the IMF in surveillance and liquidity provision; risk management systems of private investors and financial institutions; and harmonization of bankruptcy laws. In addition, the crisis highlighted a danger of unregulated influx of short-term capital, especially when a country does not have adequate absorptive capacity and stringent regulatory-supervisory framework to efficiently intermediate such capital flows. To some extent, the crisis could be traced to a premature liberalization of the capital account, aggravated by a rigid exchange rate regime and (explicit or implicit) government guarantees of bailouts. On hindsight, there was a view that the affected countries could have done better by imposing some forms of price control/regulation on short-term capital inflows. The crisis has also shown that a country cannot liberalize the capital account while simultaneously maintaining a fixed exchange rate and pursuing an independent monetary policy.

  • Financial assistance to the banking system, including restructuring of loans extended by foreign banks and other creditors, should have been the top priority. Otherwise, any multilateral or bilateral rescue package, whatever the amount, would not work; it would just flow out to pay domestic banks’ debts to foreign banks.

  • There is an urgent need for a swift and orderly international bankruptcy procedures in which private creditors lose some of the money they lent while debtors still have to repay some of the borrowed amounts, perhaps on easier terms and longer maturity. There was a felt need for an equivalent of the U.S. bankruptcy laws, in which a filing by a debtor is all that is needed to initiate the bankruptcy process (reorganization or outright liquidation). There is no coerced restructuring on private creditors and debtors, because they fully know in advance and in a transparent way the legally accepted procedures even before loans are made. Voluntary arrangements will not do, because international banks will just wait and wait until multilateral and bilateral rescue packages are worked out and implemented so that maturing debts are fully paid out of the loan disbursements—a far better arrangement for international creditors. But why should private creditors not lose money for mistakes in their lending decisions?

  • Another important lesson learned was that it is crucial to always keep a sound financial sector. A breakdown of the financial sector’s intermediary role and loss of confidence impacted severely on the real sector, transforming a financial crisis to a full-blown economic recession. In an era of global financial liberalization, emphasis must be placed on strong prudential regulation and supervision while ensuring good governance, transparency and public disclosure of the financial conditions of both banks and corporates. A country with inadequate regulatory framework and supervisory machinery may need to impose capital adequacy ratios much higher than the levels recommended by the BIS. However, higher capital adequacy ratios must be implemented gradually amidst major macroeconomic imbalances and great uncertainties. In addition, the legal framework for orderly exit of insolvent banks and corporates must be improved to avoid panic and minimize the high cost of financial rescue operations. A blanket guarantee of bank deposits should be replaced by a limited deposit insurance scheme with “prompt-corrective action” features, like the current FDIC of the United States. Government guarantees on foreign borrowing should be avoided and private creditors should be made to bear the consequences of any mistakes on lending decisions. On the issue of transparency and disclosure, information from the market should also be as forthcoming as that from official sources, while a mechanism to ensure that official information is interpreted correctly should be in place.

  • The Asian financial crisis has illustrated the herd behavior of investors during a boom–bust cycle: excessive capital flows followed by rapid and massive capital outflows. To some extent, this reflects an individual investor strategy not to be left behind with a relatively higher risk than others. It also showed shortcomings of the international financial system and lack of adequate legal infrastructure to handle the crisis effectively at both country and international levels. An effective way to deal with herd behavior is through transparency and disclosure, good governance and consistent macroeconomic policies. Private investors were always on the lookout for opportunities arising from inconsistent policies. Orderly procedures to deal with liquidity and solvency problems will also help facilitate swift negotiation among international creditors and debtors in times of crisis. Given the economic size of the affected countries, a close regional cooperation will bring in substantial benefits, both in preventing and resolving the crisis. These include bilateral arrangements to share information, enhance liquidity during the crisis, and other agreements concerning trade and payments. In this connection, there is an ASEAN Manila Framework to restore stability in the region’s financial markets by identifying measures to enhance and complement the IMF’s role in preventing and responding to the crisis, including regional surveillance and early warning systems. The ADB is heavily involved in this initiative.

3. THE CASE OF TAIWAN

The reasons why Taiwan came out of the crisis in relatively better shape were discussed. First, Taiwan had been enjoying current account surpluses since the 1980s. Such a prolonged period of surpluses, together with a precautionary attitude since Taiwan (a non-member of IMF) cannot draw on the IMF resources for its liquidity needs during emergency, permitted Taiwan to accumulate large international reserves. Second, Taiwanese firms have not been as highly leveraged as those in other countries as they prefer equity to debt financing. This minimized foreign borrowing and improved the resilience of the private sector. Third, like the Philippines, Taiwan had just recovered from its own asset price bubble crisis in the late 1980s, which caused a severe correction in the stock and real estate markets. The adjustments that followed help to strengthen the financial system as the authorities enforced stricter prudential regulation and supervision while banks had become more cautious toward lending backed by real estate or shares. For instance, the banking sector’s exposure to loans backed by shares only accounted for 2 percent of total bank lending. Finally, the government’s cautious stance in liberalizing the financial and capital markets helped to insulate the domestic sector from volatile international capital movements.

The case of Taiwan illustrates a general point about the careful liberalization of the capital account when the country was not in a position to channel the large influx of capital to productive sectors and when supervision and regulation of financial institutions were weak. There were four virtues that helped Taiwan weather the financial storm: large foreign exchange reserves and a timely introduction of a flexible exchange rate; a strong and sound banking system; low debt-equity ratio in the corporate sector; sound monetary and fiscal policies; and a well-diversified export sector.

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