Abstract

In many respects, the Asian crisis differed from previous financial crises that created a need for the IMF's assistance. It was rooted primarily in financial system vulnerabilities and other structural weaknesses, and it occurred in the context of unprecedentedly rapid moves toward financial market globalization. Conventional fiscal imbalances were relatively small; and only in Thailand were significant real exchange rate misalignments evident.

In many respects, the Asian crisis differed from previous financial crises that created a need for the IMF's assistance. It was rooted primarily in financial system vulnerabilities and other structural weaknesses, and it occurred in the context of unprecedentedly rapid moves toward financial market globalization. Conventional fiscal imbalances were relatively small; and only in Thailand were significant real exchange rate misalignments evident.

Despite several differences in specific aspects of the crisis in Indonesia, Korea, and Thailand, some broad similarities are evident across the three countries. In all three countries, weaknesses in financial systems, stemming from inadequate regulation and supervision and (to varying degrees) a tradition of government guarantees and a heavy governmental role in credit allocation—and weaknesses in governance at a more general and fundamental level—had been evident in the misallocation of credit and inflated asset prices. Another critical fragility that all three countries shared was associated with large unhedged private short-term foreign currency debt in a setting where corporations were highly geared; in Korea and Thailand, this debt was mainly intermediated through the banking system, while in Indonesia the corporations had heavier direct exposures to such debt. Economic and financial data that were inadequate for making informed decisions contributed to these imbalances, as did inadequate risks assessment and low interest rates in creditor countries. The limited degree of exchange rate variability prior to the crisis encouraged the large-scale, unhedged foreign currency borrowing, also making currencies vulnerable to speculative attacks.

Short-term foreign-currency-denominated debt created two kinds of vulnerabilities in these economies. First, fears that spark liquidity attacks can be self-fulfilling, analogous to the possibility of bank runs in the absence of deposit insurance.1 If other creditors are pulling their money out, each individual creditor has an incentive to join the queue, and the result is that even a debtor that had been fully solvent before the attack could be plunged into insolvency.2 A second vulnerability is associated with the exchange rate exposures such debt entails; to varying degrees in the three countries, exchange risk was either borne by financial institutions, passed on to corporations as the funds were on-lent (thereby converting exchange risk into credit risk, from the financial institutions' standpoint), or borne directly by corporations that engaged in foreign borrowing. These elements are further complicated by the interaction of exchange rate and credit risks: if currency depreciation, possibly resulting from a liquidity attack, leads to widespread insolvency, this creates additional counterparty risk that adds momentum to the exit of capital. Any decline in market confidence can thus become both self-sustaining and contagious across countries.

In this setting, even a moderate deterioration in macroeconomic conditions could have a disproportionate effect. In 1996, following years of rapid growth, all three countries experienced a deceleration of export growth coupled with a negative terms-of-trade shock, which put pressure on external balances and domestic economic activity. As growth slowed, the quality of asset portfolios deteriorated further and the underlying weaknesses in the financial sector became increasingly evident, raising concerns among foreign investors about the creditworthiness of financial institutions. In addition, financial sector fragilities heightened the cost of using interest rates to defend prevailing exchange rate regimes, raising doubts about the authorities' willingness to defend their currencies should a speculative attack occur.

Financial tensions had been evident in all three countries for some time before the crisis. They were particularly severe in Thailand, where macroeconomic imbalances, reflected in a large current account deficit and an overvalued real exchange rate, were more pronounced than in the other two countries. Following months of financial turbulence and speculative activities in the foreign exchange market, Thailand was forced to float the baht on July 2, 1997 in the face of serious difficulties in rolling over short-term debt and a depletion of net foreign exchange reserves. Strong downward pressures on the currency drove the authorities to request an exceptionally large Stand-By Arrangement with the IMF. In the ensuing months, the currency continued to depreciate, accompanied by mounting liquidity and insolvency problems in both financial and nonfinancial institutions. The financial vulnerabilities made it easy for the crisis to spread throughout the region, notably to Indonesia and Korea, which also requested IMF arrangements with access far above the usual limits; these arrangements were approved by the IMF's Executive Board in November (Indonesia) and early December (Korea).3

This background to the crisis is discussed below, drawing on more detailed treatments elsewhere,4 to set the stage for presenting the strategy of the programs later in the paper.

Financial Vulnerabilities

Stock imbalances at various levels were at the core of financial sector fragilities in the crisis countries. They were rooted in deep-seated structural weaknesses, including a long history of promoting domestic investment through policy loans and guarantees for corporate debtors, which obviated the need for thorough risk assessment; implicit guarantees on banks' liabilities, which did not encourage close monitoring of financial institutions by depositors and other creditors;5 and lax regulatory frameworks, which failed to set and enforce standards for sound banking operations. Another factor was connected lending: that is, the tight connections between banks and borrowing customers (for example, the ownership of weakly regulated banks by nonfinancial corporations in Indonesia). This environment created incentives for lenders to take high risks and encouraged excessive borrowing to finance risky and often doubtful investment projects.6 As a result, banks' balance sheets exhibited substantial amounts of nonperforming loans,7 increasing exposures to the property sector,8 large holdings of corporate stocks (mainly in Korea), and low capital-asset ratios. Many insolvent financial institutions were permitted to continue operations. In Korea and Thailand, large corporations were highly leveraged, aided, among other things, by a complex system of debt guarantees within chaebol (Korea) and a relatively generous tax treatment of corporate debt compared to equity (Thailand).9

These imbalances were compounded and at the same time obscured by large capital inflows which, together with high domestic savings, helped fuel strong investment and growth. These capital flows also reflected conditions in the global financial system, including low interest rates and weaknesses in risk management in industrial countries. In 1990–96, net capital inflows averaged an annual 10 percent of GDP in Thailand, 3½ percent in Indonesia, and 2½ percent in Korea. Financial institutions played an important role in intermediating these inflows (especially in Korea and Thailand) or by providing guarantees on direct foreign borrowing by corporations. While, on the whole, the IMF and the authorities were aware of the magnitude of these inflows, and some concern was expressed, this concern was tempered by the perception that the inflows were attributable mainly to favorable investment prospects associated with a stable macroeconomic environment and high growth. In hindsight, however, it appears that the inflows were to a considerable extent financing asset price inflation and an accumulation of poor-quality loans in the portfolios of banks and other financial intermediaries.

A key element of vulnerability associated with these inflows was the prevalence of unhedged short-term foreign currency borrowing. This was to some extent a prudential issue, as it was reflected in currency and maturity mismatches in the portfolios of banks and other financial institutions. It also implied aggregate vulnerability for these countries: as shown in Figure 2.1, while foreign debt as a percentage of GDP increased in all three countries (although only slightly in Indonesia), short-term debt rose considerably faster than total debt. Growth in short-term foreign liabilities also outpaced growth in available international reserves and created the potential for liquidity problems. Short-term debt exceeded gross international reserves in all three countries for over two years prior to the onset of the crisis; in Korea, reserves had declined to about one-third of short-term debt by the end of 1996.10

Figure 2.1.
Figure 2.1.

Indonesia, Korea, and Thailand: External Debt and International Reserves1

Sources: International Monetary Fund, International Financial Statistics and World Economic Outlook; and IMF staff estimates.1 External debt figures are in percent of GDP. Gross reserves exclude gold.2 Debt figures include offshore borrowing of domestic financial institutions and debt contracted by overseas branches of domestic financial institutions. Reserves exclude deposits at overseas branches and subsidiaries of domestic banks.3 Reserves figures for the last three quarters of 1997 are net of forward operations.

The prevalence of unhedged foreign currency borrowing reflected various incentives that had free play in the context of a deregulated domestic financial environment with lax supervision. Domestic interest rates that were above foreign rates,11 together with a lack of exchange rate variability,12 provided an incentive for borrowing in foreign exchange, most of which was unhedged. Borrowers may have underestimated the risks associated with foreign currency exposure and shunned the cost of hedging such exposure, which would have raised the cost of foreign borrowing close to domestic interest rates.13 Lenders, for their part, may have ignored the fact that exchange rate risk for their debtors meant credit risk for them. Short-term foreign borrowing was also encouraged by the governments through the provision of explicit or implicit guarantees, and in Thailand was even institutionalized and subsidized through the creation of the Bangkok International Bank Facility (BIBF)—a tax-exempt entity specialized in short-term borrowing from abroad and on-lending in the domestic market.

Macroeconomic Considerations

The financial vulnerabilities discussed above had been accumulating for some time, but became particularly problematic as macroeconomic conditions began to worsen. Following strong growth in 1994–95, economic activity in the three countries slowed in 1996 (figure 2.2),14 and overcapacities built up during the preceding investment boom (particularly in Korea) became increasingly evident. In Korea and Thailand, the deceleration in production was more pronounced and led to increases in unemployment rates, while in Indonesia the economy continued to operate at close to its productive capacity. The slowdown in output growth reflected a marked deceleration of export growth against the background of weakening demand in partner countries and modest real effective appreciations,15 which in Indonesia and Thailand led to a fall in export market shares (Figures 2.3 and 2.4). In general, inflation was relatively low in all three countries during the 1990s.

Figure 2.2
Figure 2.2

Indonesia, Korea, and Thailand: Growth and Unemployment

(In percent)

Source: International Monetary Fund, World Economic Outlook.1 Reliable data on unemployment rates for 1990–96 were not available for Indonesia.
Figure 2.3.
Figure 2.3.

Indonesia, Korea, and Thailand: Exchange Rate Developments

(January 1995—June 1997; Indices, 1990 = 100)1

Source: International Monetary Fund, International Financial Statistics.1 An increase denotes an appreciation.
Figure 2.4
Figure 2.4

Indonesia, Korea, and Thailand: Competitiveness Indicators

Sources: International Monetary Fund, World Economic Outlook; and IMF staff estimates.

In addition to weakening export growth, the three countries were affected—to different extents—by the sharp decline in prices of key export commodities, such as semiconductors. As a result, export revenues fell in Korea and Thailand, and grew only modestly in Indonesia. Current account imbalances remained large (Thailand) or widened significantly (Korea), as high domestic investment continued to outstrip national saving.

The fiscal situation in all three countries was apparently sound for many years prior to the crisis (although the implicit liabilities associated with government guarantees to weak financial institutions imply that these positions were weaker than they appeared). Both Korea and Indonesia ran surpluses prior to the crisis, following small deficits at the beginning of the 1990s (Figure 2.5). In Thailand, significant surpluses were recorded every year from 1990 through 1996. Prudent fiscal policies combined with high rates of economic growth led to rapidly declining public debt ratios in all three countries: at the end of 1996, government debt amounted to about 25 percent of GDP in Indonesia, and less than 10 percent in Korea and Thailand.

Figure 2.5.
Figure 2.5.

Indonesia, Korea, and Thailand: Central Government Balances

(In percent of GDP)

Source: International Monetary Fund.1 Fiscal year is April 1 to March 31.2 Including Natioanal Pension Fund. Fiscal year is the same as the calendar year.3 Fiscal year is October 1 to September 30.

Monetary policies helped fuel the expansion during the 1990s with rapid money and credit creation. Growth in total domestic credit considerably exceeded nominal GDP growth in all three countries and was particularly strong in 1993–94 (Figure 2.6). Given lax banking supervision, these surges in credit growth were liable to result in a deterioration in the average quality of banks' portfolios.

Figure 2.6.
Figure 2.6.

Indonesia, Korea, and Thailand: Domestic Credit Expansion in Comparison to Nominal GDP Growth

(Annual percentage changes)

Sources: International Monetary Fund, International Financial Statistics; data provided by the authorities; and IMF staff estimates.

Asset Price Deflation and Bank Failures

Declining asset prices provided one of the earliest signs of trouble in the region. During 1996, stock prices (in domestic currency terms) fell by more than 20 percent in Korea and by almost one-third in Thailand (Figure 2.7). The decline continued in Thailand in early 1997; in Korea, it was temporarily interrupted in the first half of the year but continued in the second half. In Indonesia, stock prices increased through mid-1997, but fell dramatically in the aftermath of the Thai crisis.16 In addition, property prices dropped significantly, particularly in Thailand and (after the crisis broke) in Indonesia.17

Figure 2.7.
Figure 2.7.

Indonesia, Korea, and Thailand: Stock Market Prices

(Domestic currency indices; January 1996 = 100)

Source: International Monetary Fund.

The declines in stock and property prices and the slowdown of economic activity reinforced each other,18 aggravated the stock imbalances, and led to a self-perpetuating process of bankruptcies and bank failures in all three countries. In Indonesia, a run on the deposits of Lippo Bank in November 1995 and the support given by Bank Indonesia to two ailing banks in 1996 brought attention to the fragile state of the banking sector, which had expanded at an extraordinary pace in the wake of banking sector liberalization in the late 1980s. In Korea several of the largest chaebol posted losses in 1996 and 6 of the top 30 went bankrupt in 1997 before the crisis broke. This weakened the already fragile situation of several commercial and merchant banks and led to increasing difficulties in external financing. In Thailand, Thai-owned commercial banks reported a significant increase in nonperforming loans in late 1996 and there was a run on the deposits of the Bangkok Bank of Commerce in May 1997. These tremors in the financial sector, together with the loss of foreign exchange reserves, culminated in a funding crisis that led to the collapse of the exchange rate regime.

1

This risk does not depend on the unhedged nature of the borrowing, since in general a currency hedge does not protect against liquidity and credit risks.

2

The case of a self-sustaining bank run, whereby a previously solvent bank that undergoes a bank run may have to liquidate assets on unfavorable terms and thereby become insolvent, has been analyzed by Diamond and Douglas (1983). This pattern, where self-fulfilling expectations lead to a change in fundamentals, is the essence of so-called second generation models of speculative attacks; for a review of these models, see for instance Obstfeld (1996). Radelet and Sachs (1998) focus on the role of this kind of self-justifying behavior in the Asian crisis.

3

The evolution of exchange rates through the crisis is shown in Figure 6.1 (Section VI). For a detailed chronology of the crisis, see International Monetary Fund (1997).

4

For instance, International Monetary Fund (1997); Charles Adams and others (1998); and various academic studies. Three recent outside studies of the crisis are Corsetti, Pesenti, and Roubini (1998); Goldstein (1998); and Radelet and Sachs (1998).

5

Despite the absence of formal deposit insurance, holders of deposits in the domestic financial institutions in these countries may well have operated under the assumption that the government guaranteed those deposits and thus felt no need to keep close track of these institutions' soundness. While this is a feature of most countries' banking systems, it creates a need for effective supervision to ensure that institutions do not take excessive risks, but such supervision was lacking.

6

This explanation of the crisis is elaborated in Krugman (1998) and Dooley (1997).

7

Official precrisis estimates of nonperforming loans generally underestimated their magnitude. For a comparison of official and unofficial estimates of nonperforming loans in Indonesia, Korea and Thailand, see Berg (forthcoming).

8

By end-1997 the share of loans to the property sector in total loans was of the order of 30–40 percent in Thailand, 20–30 percent in Indonesia, and 15–25 percent in Korea. See Goldstein (1998), p. 8.

9

In Korea and Thailand, for example, average ratios of corporate debt to equity were 395 percent and 450 percent, respectively. Such ratios elsewhere, including in Asia, tend to be much lower (for instance, in Germany, 144 percent; Malaysia, 160; Japan, 194; Sweden, 154; Taiwan, Province of China, 90; and the United States, 106). These high debt-equity ratios also reflected features of the tax system, including the absence of thin capitalization rules and comparatively low effective tax rates on interest income.

10

At the same time, gross reserves were a poor indicator of available international liquidity given the magnitude of liabilities set against these reserves (many appearing off-balance sheet). Of particular importance in Thailand were forward contracts out-standing; in Korea, reserves were also lent to commercial banks via a special fund, as discussed below. (The latter reserves, how-ever, are excluded from the figures presented in Figure 2.1.) These components were significant mainly in 1997. As data on usable reserves and comprehensive data on short-term debt were available only in the wake of the crisis, the detailed picture presented in Figure 2.1 was only known after the crisis erupted.

11

This was particularly the case as regards yen rates, given Japan's close trade and financial ties with the region.

12

The nominal exchange rate was essentially pegged to the U.S. dollar in Thailand, and depreciated in a reasonably predictable manner in Indonesia. In Korea, exchange rate policy sought to keep the won broadly stable in real effective terms.

13

At the same time, global financial markets apparently did not put full confidence in the exchange rate peg, as indicated by the premium of domestic currency over dollar interest rates.

14

For a detailed description of macroeconomic developments in the region prior to the crisis, see International Monetary Fund (1997).

15

The strengthening of the U.S. dollar vis-á-vis the Japanese yen and other major currencies since 1995 may have been another important factor affecting competitiveness in the crisis countries, whose currencies were more or less formally linked to the dollar. Some authors (Fernald and others, 1998) have examined the role of the large devaluation of China's official exchange rate in early 1994. However, the effective depreciation of the renmimbi at the time was relatively modest as most exchange transactions were already being carried out at the more depreciated (and unchanged swap) market rate.

16

Earnings, on the other hand, grew slightly in 1996 but fell in late 1997. Movements in prices went beyond changes in underlying earnings.

17

Inflation-adjusted residential property prices fell by almost 50 percent between end-1991 and end-1997 in Thailand; by about one-third between late 1992 and mid-1997 in Indonesia; and by about one-fourth between mid-1990 and end-1997 in Korea (Bank for International Settlements, 1998, p. 140).

18

Decliningasset prices depressed economic activity through negative wealth effects on domestic demand, while the deteriorating outlook for growth put pressure on asset prices.

References

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Cited By

  • View in gallery

    Indonesia, Korea, and Thailand: External Debt and International Reserves1

  • View in gallery

    Indonesia, Korea, and Thailand: Growth and Unemployment

    (In percent)

  • View in gallery

    Indonesia, Korea, and Thailand: Exchange Rate Developments

    (January 1995—June 1997; Indices, 1990 = 100)1

  • View in gallery

    Indonesia, Korea, and Thailand: Competitiveness Indicators

  • View in gallery

    Indonesia, Korea, and Thailand: Central Government Balances

    (In percent of GDP)

  • View in gallery

    Indonesia, Korea, and Thailand: Domestic Credit Expansion in Comparison to Nominal GDP Growth

    (Annual percentage changes)

  • View in gallery

    Indonesia, Korea, and Thailand: Stock Market Prices

    (Domestic currency indices; January 1996 = 100)