Back Matter
Author: Mr. Andrew Berg

APPENDIX I

The Run-Up to the Crisis61

Thailand

Thailand’s crisis was in many ways predictable on the basis of a deterioration in all the areas of weakness mentioned above. The macroeconomic situation was deteriorating by 1996. During 1993-95, demand pressures intensified, leading to higher inflation and a sharp widening of the current account deficit. As monetary and fiscal policies were tightened, the combination of the pegged exchange rate and increasingly open capital account resulted in large capital inflows, much of which were short-term. At this point, the macroeconomic problems interacted with the weak financial system to create domestic and external vulnerabilities. The capital inflows were intermediated primarily by commercial banks and finance companies, leading to rapid credit growth—especially to the property sector—and growing concerns about asset quality. At the same time, many domestic companies acquired large unhedged foreign exchange positions, as a result of rapid borrowing in dollars.

The situation deteriorated sharply during 1996. Export growth slowed sharply, in part due to an appreciation of the baht as the dollar, to which the baht was pegged, appreciated, and partly due to increased competition particularly from China.62 Though imports slowed as well, the current account deficit remained high. As market confidence ebbed, the stock market dropped steeply and the property sector weakened, exacerbating the deterioration in asset quality in the financial system. In the 12 months leading up to the July devaluation, the government took over the Bangkok Bank of Commerce, several banks’ credit ratings were downgraded, the largest finance company was intervened and merged with a bank, and there were runs on several finance companies’ deposits. Capital inflows slowed and there were four, increasingly intense, speculative attacks on the baht after July 1996. As the situation worsened, Moody’s downgraded short-term sovereign ratings in September 1996 and long-term sovereign ratings in March 1997. Aggravating the situation was a sharp deterioration of the fiscal stance, with a deficit forecast to grow by more than three percent of GDP in 1996/97.

In the face of the worsening external environment, the Thai authorities policy response was piecemeal. The Bank of Thailand began in early 1997 supporting the currency largely through an unreported forward sale of baht, with the stock of forward sales outstanding rising from about 5 billion dollars at the end of 1996 to about 30 billion at the end of June 1997, roughly equal to the stock of reserves. Meanwhile, several percent of GDP was spent by the government supporting financial institutions in the first half of 1997. As the May speculative attack mounted, the authorities accelerated their forward sales of foreign exchange and in June suspended 16 finance companies that had received several times their equity in support. None of these measures succeeded in defeating the pressure on the exchange rate. Short-term interest rates had been kept fairly low, but they finally increased above 20 percent in late June as pressure mounted. Finally, the authorities allowed the exchange rate to float on July 2.

Korea

Korea was characterized by a deteriorating financial situation in the financial and corporate sector well prior to the final attack on the won in October 1997. As discussed above, already low ratios of corporate profits to interest costs fell further in 1996, partly do to an external shocks in the form of a sharp deterioration of the terms-of-trade and abetted by the appreciation of the won vis a vis the yen in 1996. Six Chaebol went bankrupt in 1996 and first half of 1997. Meanwhile, the banking system grew weaker as well into 1997. Non-performing loans tripled to 7.5 percent of GDP at end-September 1997 from end-1996. An index of bank stock prices fell by 67 percent from its peak (August, 1991) to late October, much more than an index of manufacturing stocks.

External finance began drying up for Korea even prior to the Thai devaluation in July 1997, a investors became increasingly concerned about the looming domestic financial problems. Usable reserves had already begun to fall and short-term external debt accumulated in the first half of 1997 as the situation deteriorated (Table 5). The Bank of Korea reported reserves of about $33 billion at the end of 1996, $29 billion at end-March and $31 billion at end-October 1997. In fact, though, many of these reserves had already been placed with foreign branches of Korean banks that had become illiquid. When Korean banks used these dollars to satisfy demands for dollars from creditors who did not roll over dollar obligations, the reserves were essentially used. These deposits of unavailable reserves already amounted to $3.5 billion at the end of 1996, but with overseas branches of Korean banks coming under increasing liquidity pressure with the growing weaknesses in the corporate sector, the Bank of Korea extended further support, so that the stock rose to $8 billion by end-March 1997.63

The Korean won came under increasing pressure after the Thai devaluation and particularly after the devaluation of the New Taiwan dollar in mid-October and the subsequent brief but violent attack on the Hong Kong yuan. The authorities responded with In response, authorities announced an intent to defend the won and address financial sector problems. The majority party proposed to clean up debt-ridden banks and encourage foreign investment, but the bill failed to pass the legislature. After substantial foreign exchange intervention but little increase in interest rates, Korea abandoned the defense of the won on November 17. Korea began to negotiate an IMF package on November 21 and announced its agreement on December 4th.

Indonesia

Indonesia appeared in early 1997 to be in substantially better shape than Thailand on essentially all counts. The export slowdown was smaller, reserve growth was strong, the fiscal stance was not loosening, the current account deficit was smaller, the exchange rate was less appreciated, and the recourse earlier to a more flexible exchange rate regime implied more ability to withstand shocks. There was little evidence of property price declines in Jakarta, and little sign of weakness in the stock market.

There were important vulnerabilities, however. The stock of short-term external debt had risen to high levels, though information was extremely scarce as the debt was contracted not by the government or banking system but largely by private non-financial corporations directly with foreign creditors. Within the banking sector, growth in exposure to property lending had been rapid (rising from 11 percent to 20 percent of total loans in three years). Moreover, there was a lack of aggressive bank closures with insolvent institutions continuing to function.

After the Thai devaluation, the rupiah came under pressure as Indonesia’s large stocks of short-term external debt and weak banking system left it vulnerable to capital outflows. Indonesia mounted a vigorous interest rate defense, with over-night rates rising to near 100 percent, but with fears of banking system collapse mounting the authorities chose to allow rates to come down and to float the rupiah on August 14. By end-October, Indonesia was already as hard hit as Thailand. Indonesian corporates were finding it increasingly difficult to rollover maturing short-term external credits. The recourse of these debtors to foreign exchange markets to replace the lost foreign exchange placed increasing pressure on the rupiah as well as on local currency interest rates. The damage the resulting high interest rates were doing to the banking system reduced confidence in the ability of the authorities to maintain policies, and indeed they responded by lowering interest rates, which in turn worsened the downward pressure on the exchange rate. The weakness in the banking system was thus a result of the maturing short-term external debt, aggravated by thinness of financial markets, with the banking system already badly hurt by increases in interest rates and declines in the exchange rate.

At the end of October Indonesia announced a $23 billion external assistance package led by the IMF with support from the World Bank and Asian Development Bank as well as bilateral donors.

Malaysia

Malaysia’s situation prior to the crisis looked strong in many ways. In terms of macroeconomic indicators, growth was strong but overheating was reduced in 1996, with the current account deficit declining. The financial sector appeared robust, with measured non-performing loans declining from 20 percent of total loans in 1990 to under 4 percent in 1996. Capital adequacy ratios in the banking system appeared high, while the supervisory and regulatory framework was generally deemed strong. There was little dependance on foreign capital, particularly, short-term flows, with strict controls on short-term borrowing, net foreign exchange positions of banks, and off-balance-sheet activities.

There were some important warning signs nonetheless. The current account deficit at over 5 percent of GDP was still large. Exports had slowed, in large part due to falling foreign demand and some real appreciation of the ringitt, though also because of increased competitive pressures from China and elsewhere. In terms of domestic financial vulnerability, domestic credit growth remained strong, particularly in the consumption and property sectors. While property prices were fairly stable, there were concerns that a coming surge of supply could depress prices, particularly in an economic downturn.

After the Thai devaluation, the ringitt came under strong pressure and was floated, after brief interest rate defenses and some intervention, on July 14.

The Philippines

The Philippines was in a period of improved economic performance. Macroeconomic stability had been established, with stronger fiscal performance and good economic growth. The banking system was still recovering from serious problems early in the decade. External vulnerabilities appeared the most pronounced, with short-term external debt representing a fairly high fraction of reserves at the end of 1996 at about 70 percent. The amount subject to rollover risk, however, was judged to be relatively small. The degree of dollarization in the banking system was a source of concern, with foreign currency deposits of about $11 billion.

The peso also came under pressure after the Thai devaluation and was floated, after brief interest rate defenses and some intervention, on July 11.

APPENDIX II

The Unfolding of the Crisis

The evolution of events in each country cannot be understood except in the context of the unfolding of the crisis in the region.64 This section briefly reviews the major developments in Indonesia, Korea, Malaysia, the Philippines and Thailand from July 2, 1997 to May, 1998. The crisis as a whole can be divided into five phases.65 (Figures 4a and 4b show daily interest and exchange rates by country for the entire period, while Figures 5, 6, and 7 show nominal exchange rates, stock market indices, and spreads on dollar-denominated sovereign issues respectively).

1. Weakness in ASEAN Countries: July 2 to October 23,1997

After the Thai devaluation, the currencies of Indonesia, the Philippines, and Malaysia came under the most pressure. The Philippine peso and the Malaysian ringitt were floated, after brief interest rate defenses and some intervention, on July 11 and July 14 respectively. Indonesia mounted a vigorous interest rate defense, with over-night rates rising to near 100 percent, but with fears of banking system collapse mounting the authorities chose instead to float the rupiah on August 14.

On August fifth Thailand unveiled an austerity plan and program to restructure the financial sector in the context of the IMF support package, which was approved on August 20th. The financial program was designed to be a comprehensive plan to (I) identify and close insolvent institutions to preserve the system; (ii) provide a government guarantee of bank depositors to maintain confidence; and (iii) implement broad-based structural and regulatory reforms to provide stronger framework for the long term. 58 finance companies (including 16 already identified prior to the devaluation) were to be suspended. The announcement of the program had a brief positive impact but did not stem the tide, partly due to continued concerns about the health of the financial system and lack of information about the government’s policy commitments.

Through October, all four currencies tended to weaken, as a stream of bad news emerged. The existence of Thailand’s $23 billion in outstanding forward contracts surprised markets in October. While the implications of these forward contracts for Thailand’s usable reserve position was not well understood, the initial reaction was to calculate reserves net of this amount, which apparently left the central bank with little “net” reserves. Fears grew about the solvency of the Thai banking system, with Standard & Poor’s downgrading seven institutions in September. Meanwhile, Malaysian authorities issued contradictory policy statements and attacked “rogue speculators” as the source of the problems in the region. Growth and profit forecasts were revised downward in all the countries. In the Philippines, concerns regarding the health of the banking system were relatively muted.

By October 22, exchange rates had fallen by 51 percent in Indonesia, 60 percent in Thailand, 34 percent in Malaysia and 32 percent in the Philippines (The Korean won had remained stable).

2. Crisis Spreads to Korea: October 23 to December 4,1997

The second stage began with the devaluation of the New Taiwan dollar in mid-October and subsequent brief but violent attack on the Hong Kong dollar and ended with Korea’s IMF agreement in early December. The attack on Hong Kong’s currency board was followed by pressure on a number of emerging market exchange rates worldwide, including Brazil and Russia. While the ASEAN countries maintained some stability, the Korean won came under increasing pressure. Korea announced an intent to defend the won and address its financial sector problems. The majority party proposed to clean up debt-ridden banks and encourage foreign investment, but the bill failed to pass the legislature. After substantial foreign exchange intervention but little increase in interest rates, Korea abandoned the defense of the won on November 17. Korea began to negotiate an IMF package on November 21 and announced its agreement on December 4th.

Meanwhile, the Indonesian rupiah came under increasing pressure. Although relatively unscathed early on, Indonesia was already as hard hit as Thailand by end-October. Indonesian corporates were finding it increasingly difficult to rollover maturing short-term external credits. The recourse of these debtors to foreign exchange markets to replace the lost foreign exchange placed increasing pressure on the rupiah as well as on local currency interest rates. The damage the resulting high interest rates were doing to the banking system reduced confidence in the ability of the authorities to maintain policies, and indeed they responded by lowering interest rates, which in turn worsened the downward pressure on the exchange rate. The weakness in the banking system was thus a result of the maturing short-term external debt, aggravated by thinness of financial markets, with the banking system already badly hurt by increases in interest rates and declines in the exchange rate.

At the end of October Indonesia announced a $23 billion external assistance package led by the IMF with support from the World Bank and Asian Development Bank as well as bilateral donors. Monetary policy was to be geared to defend the exchange rate, though with consideration given to the effects of high interest rates on the financial system. The strategy of the financial sector package was to preserve a healthy core by eliminating unviable banks, to avoid a spread of panic. On November 1 the authorities closed 16 banks and placed a number of others under receivership as part of a broader program to improve supervision recapitalize, and implement broad structural reforms. The initial reaction was not as positive as had been hoped for. Confidence in the banking system was not restored, as deposits fled from weak banks that had not been closed to state and foreign banks and out of the system entirely, while foreign loans continued to be withdrawn. The authorities responded by increasing liquidity, lowering interest rates back towards pre-crisis levels. Nonetheless, the exchange rate stayed reasonably stable during this period.

3. Near-Default in Korea, Collapse in Indonesia: December 1997

In the third phase, from late November to late December, the situation in Korea and Indonesia deteriorated sharply, bringing renewed pressures on the rest of the countries. The revelation at the time of the IMF program announcement that Korea had almost no usable reserves left, and doubts about the size of the official support package, brought foreign credit roll-over rates to very low levels and raised serious concerns of default. Bank closures failed to restore confidence in the banking system, in part because of doubts about many remaining banks. The election of dissident Kim Dae-jung as president on December 18 initially raised further concerns, as he had been the candidate least supportive of the IMF agreement. In Indonesia, rumors that president Suharto was gravely ill precipitated a further sharp slide in the rupiah at about the same time as the won moved sharply lower, in early December. As rollover rates on external credits fell to very low levels, fears of imminent default intensified towards the end of December, both in Indonesia and Korea.

On December 24, the announcement of a strengthened Korean program, supported by further IMF disbursements and bilateral support, began to help turn around the climate, with roll-over rates on external debt increasing. Discussions began between creditor banks and Korean authorities about a concerted roll-over of short-term credits into medium-term loans, with the strong support of creditor banks’ governments.

The Malaysian, Philippine and Thai currencies were all caught up in the worsening external climate through this period as all fell to new lows, with the won and the rupiah, in early January.

4. The Beginning of Recovery: January to May 1997

The fourth phase, beginning in early January, marked the bottom of the crisis and the beginnings of recovery for most of the countries, as well as signs of more substantial differentiation among the countries by investors. Late December agreement by most of Korea’s creditor banks to roll-over their claims while negotiating a voluntary rescheduling, along with IMF and bilateral support and firmer implementation of reforms, caused fears of default in Korea to recede and the won recovered. The stock of short-term debt had shrunk to about $40 billion dollars with the finalizing of the debt restructuring agreement in April. In this same month Korea returned to private capital markets with a successful $4 billion dollar sovereign issue. Meanwhile, the GDP decline appeared to be much steeper than hoped. Small and medium enterprises, in particular, faced a cut-off of credit in part due to the devastation in the merchant banking sector that had served them disproportionately.

The Thai baht also recovered strongly, partly on strong policy implementation by the new government that took office in December. The implementation of the financial restructuring plan gained momentum, as four weaker banks were taken over and depositors protected, and new loan classification and provisioning rules were approved at end-March. Bank recapitalization, largely through private capital injections, proceeded faster than many market participants had expected. GDP growth estimates continued to fall, however, and corporate debt problems worsened.

The Malaysian ringitt and the Philippine peso also recovered strongly from early January lows.

Indonesia’s path diverged somewhat during this fourth phase. The rupiah weakened sharply throughout January, with a brief pause in mid-month. By this point, the severity of the decline in the real economy was apparent. Most firms were technically bankrupt and many were defaulting on external and internal payments. The financial position of the banks continued to deteriorate. Funds continued to flee the banking system and the currency, and by early January foreign interbank lines of credit were being cut even to state banks.

Many factors contributed to this poor performance. The authorities failed to demonstrate strong commitment to the reform program. On monetary policy, the central bank felt that it could not tighten without causing payments problems. The budget announced on January 6 appeared to be based on unrealistic economic assumptions. There was backtracking on important elements of the structural reform program. Some important steps were taken, however, including to restructure the financial sector, reduce tariffs, and increase excise taxes.

The January 15 adjustment to the program focussed on an enlarged structural reform agenda, to eliminate virtually all barriers to external trade, abolish almost all domestic monopolies, and significantly increase transparency in the public sector. It also emphasized a strengthening of the social safety net. The announcement of this program failed to stem the decline, however.

The rupiah started a protracted recovery at the end of January, when new measures to restore the banking system to health and carry out a broad range of reforms were implemented. A guarantee of the rupiah value of depositors and bank creditors (excluding subordinated debt holders) was announced, while a “bridge bank” (the IBRA) was created to rehabilitate and restructure unsound banks, recapitalizing banks and purchasing bad loans. Almost immediately, funds started flowing back into the banking system. With regard to the foreign debt situation, the authorities, with the support of the IMF and bilateral creditors, encouraged debtors and creditors to group together to develop a framework for debt restructuring that was to be private sector-led, voluntary, and without public subsidy or guarantee. They also promised stronger structural reforms: monopolies, trade deregulation, marketing arrangements eliminated, FDI barriers and external tariffs reduced.

Indonesia’s recovery was partial and interrupted, however. While the exchange rate appreciated from its lows, weak implementation of structural reforms, a failure to restore confidence in the banking system, and fears of social unrest and doubts about the survival of the Suharto regime continued to generate capital outflows. Foreign credit lines, including trade credits, continued to be cut.

Towards the end of this phase, some clearer signs of progress were, evident in Indonesia. While the plan to voluntarily restructure external corporate debt did not make much progress by mid-March, a corporate debt initiative announced as part of the April revision to the IMF program provided some confidence. The April program included a commitment to firm monetary policy, a revamping and acceleration of bank restructuring, far-reaching structural reforms, and some budget loosening to accommodate subsidies and financial costs while still depending on foreign financing, and a new corporate debt workout mechanism with a limited government role. Augmented official financing and efforts to encourage the maintenance of foreign credit lines and trade credit would, it was hoped, combine with the other measures to restore stability to the exchange rate.

5. Renewed Weakness as Yen Slides: Starting Mid-May 1997

The fifth phase began in mid-May, with a further round of weakness triggered largely by renewed weakness in the Japanese yen and related concern regarding the possibility of a devaluation of the Chinese renminbi. Most of the currencies weakened but stabilized by June. Estimates of the depth of the recessions in all the countries continued to mount. Nonetheless, restructuring programs seemed to be well under way in most of the countries. With the improving situation, authorities have been able to bring interest rates gradually down without weakening exchange rates, particularly in Thailand and Korea. In Indonesia, political and social unrest intensified in May, eventually resulting in the fall of the Suharto government.

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1

The author has benefited from discussions with David Goldsbrough, Jonathan Ostry, Ilan Goldfajn, Jeromin Zettelmeyer, Gaston Gelos, Eduardo Borensztein, Zanny Minton Beddoes, Theodore Laquercia, Katie Berg and many economists in the Asia and Pacific Department, as well as excellent research assistance from Ned Rumpeltin. This paper was largely written in 1998, while the author was attached to the Policy Research Unit of the Asia and Pacific Department.

2

Other overviews and analyses of the Asia crisis include, among many others, IMF (1997), Lane et al. (1999), Kochhar et al. (1998), Adams et al. (1998), Furman and Stiglitz (1998), Radelet and Sachs (1998a, 1998b and 1999), Corsetti et al. (1998a and 1998b), World Bank (1998), and Goldstein (1998).

3

See for example Krugman (1998). Krugman (1999) has a somewhat different view.

5

Furman and Stiglitz (1998) and Radelet and Sachs (1998a and 1998b) make this argument.

6

See Diehl and Schweickert (1998) for a discussion of exchange rate policies, including the composition of currency baskets.

7

Here “equilibrium” can be understood as that exchange rate that generates positions of internal and external balance over the medium term. See Clark et al. (1994) for a discussion of this and related issues.

8

To ascertain whether an exchange rate is overvalued in more general terms requires a model of the relationship between the exchange rate and economic fundamentals, and this has proven difficult to estimate. Chinn (1998) tries to estimate a model of exchange rates for the Asian crisis countries in which overvaluation is measured as the deviation of the actual exchange rate from that predicted by such fundamentals as could be measured. His estimates suggest no major overvaluations prior to the crises of 1997, though the poor performance of the model suggests that little confidence be placed in this result.

11

The deviation from trend real exchange rate as defined in Kaminsky et al. (1998) and calculated for Asia in Berg and Pattillo (1999a) does show overvaluations for several of the countries, including Korea. This measure is different in that the degree of overvaluation is measured in comparison to previous episodes of overvaluation for that country. Thus, a relatively small percentage deviation from trend might show up as a relatively large overvaluation in a country that has had little history of overvaluation.

13

Of course, the Asia crisis itself has modified this view that current deficits are not a problem if they are financing investment. Section B discusses the investment booms.

14

See Fernald et al. (1998) as well as Diehl and Schweikert (1998). The slowdown in export growth is correlated with the yen/dollar exchange rate for a variety of Asian countries over the 1991 to 1996 period. Among the five crisis countries, Korea has the highest correlation, suggesting the most competition with Japan, with a correlation of about 0.6, with Thailand next at about 0.4 (Kochhar et al. (1998)).

15

See BIS (1998) for a discussion of the role of financial intermediation in the Asian crisis.

16

See Gobat (1997) for a discussion of corporate governance in Korea and World Bank (1998) for the region as a whole.

17

Kaminsky et al. (1998) find that growth in bank credit helps predict bank and currency crises in a panel of some 23 countries since 1970. Sachs et al. (1996) find that growth in bank credit as a share of GDP helps explain the pattern of the Tequila effect in the wake of the Mexico crisis. And Corsetti et al (1998b) find that a lending boom helps predict the severity of the currency crisis across countries in 1997.

19

Albaetal. (1998)

21

The size of the non-performing-loan portfolios post-crisis and the cost of recapitalizing the banking system are estimated to be large, running up to as much as 30 percent of GDP (Table 2). While these may give some indication of the scale of the pre-crisis problems, they cannot be used to demonstrate that such problems caused the crisis, as the financial sector collapses in the affected countries are clearly influenced by the crisis under any interpretation.

23

Tornell (1998) finds that M2/reserves is an important predictor of the incidence of the Asia crisis in 1997. Radelet and Sachs (1998b), in contrast, find that reserves/short-term external debt helps predict crisis in the 1994-1997 period. Data on external debt (especially in Korea and Indonesia) and usable reserves (especially in Korea and Thailand) were not available prior to the crisis. The data in Table 1 reflect what we now know.

24

International banking regulations may have played a role in shaping the nature of the capital inflows. Basle standards implied that short-term bank lending to Korea (a new OECD member) received a risk-weighting of zero, much more favorable treatment than that accorded longer-term lending.

25

The appreciation of the dollar vis a vis the yen, and hence those Asian currencies linked to it, may be considered an external factor. The maintenance of a tight dollar link was a policy decision, however, particularly in the many countries where the composition of the basket to which the currency was pegged was not public.

26

This distinction between a deterioration of fundamentals leading to a crisis and a zone of vulnerability in which negative shocks may cause a crisis is important in the theoretical literature on currency crises as the first situation characterized so-called “first generation” models of currency crisis while the latter characterizes some “second-generation” models. See Flood and Marion (1998) for a review of this literature.

27

I use the term “speculative attack” in the spirit of the literature on collapsing exchange rate regimes, as in Krugman (1979). The speculators in question may be foreign banks or domestic firms or investors, for example. In particular, there should be no implication that they are “speculators” in the sense of hedge funds or other such investors. See Eichengreen et al. (1998) on the role of hedge funds in the Asia crises.

28

Appendix II describes chronologically the evolution of the crisis from July 1997 through mid-1998.

29

This point is strongly emphasized in Radelet and- Sachs (1998a).

30

In addition, the Philippines was in the third year of its IMF program. The Philippines did not receive a major “rescue package.”

31

In assessing the size of these packages, however, it is important to emphasize that in the cases of Indonesia and Korea none of the bilateral support, characterized as a “second line of defense,” has been disbursed. The bilateral support for Thailand has been made available in line with IMF disbursements.

32

Yields on sovereign dollar-denominated bonds in Korea (Figure 5) started rising in October but shot up in December before beginning to recede (though the LTCM and Russian crises in the summer of 1998 caused a further rate jump).

33

Zettelmeyer (1999) analyzes the role of external support packages in liquidity crises. In particular, he shows that underfunded programs may not halt the “rush for the exit” by investors fearful of default, where an underfunded program is essentially one that is not large enough to finance all external debt service due.

34

It is not clear that IMF members were willing to countenance even larger programs or more bilateral assistance. It may still be asked whether they should have done so.

35

The coordinated roll-over of bank debt to Korea presents an important case in point. The creditor banks involved in negotiations with the Korean authorities demanded various structural reforms to strengthen the financial system as a condition for their participation in the debt restructuring agreement.

36

Kochhar et al. (1998) present a summary of the important structural measures in the crisis countries. See also Baliño and Udibe (1999) on Korea.

37

This fairly rapid move to close insolvent financial institutions contrasts with Mexico’s approach in 1995. There, the authorities allowed all major institutions to keep functioning during the crisis, initially intervening only in cases of criminal behavior by bank managers or owners. While there were only very limited domestic bank runs in Mexico, the process of resolving the crisis in the banking industry has proved long and politically difficult.

38

Radelet and Sachs (1998a) argue that Indonesia’s bank closures were a decisive mistake in turning a precarious situation into a full-blown panic. Full deposit guarantees should have been clearly provided. However, the importance of this factor is difficult to assess. In this regard it is worth noting that Indonesia’s exchange rate remained fairly stable from the time of the bank closures in early November until the fears about President Suharto’s health and fears of default in Korea dominated market sentiment in early December.

39

See footnote 57 on the evidence for a “credit crunch.”

40

While some stabilization of the health of the Thai financial system has subsequently been observed, some private estimates suggest that roughly half of the recapitalization remains to be done.

41

The tightening of capital adequacy and provisioning requirements, in part to encourage private sector recapitalization, stands in some contrast to the response of Mexican authorities to their banking crisis in 1995 (though the provisioning requirements were to be phased in over a 21/2 year period). The move to international accounting standards that had been scheduled for 1996 was postponed until 1997 and the bank recapitalization process involved substantial public resources. This reduced the degree to which the banking system was constrained from expanding credit after the crisis, though the continued doubts of market participants about the true strength of Mexican financial institutions may have hurt confidence.

42

Goldfajn and Baig (1998) analyze in detail the question of the role of monetary policy in the aftermath of currency crises, with particular attention to Asia. The data referred to here is largely from that source.

43

Despite the government’s announced change of direction towards a looser monetary policy in September 1998, there is little sign of a break at that point -- Malaysia’s interest rates generally trend down with the other countries.

44

We have focussed here on ex poste real rates. Of course, it is not necessarily the case that market participants expected inflation to be as high as it actually was. On the one hand, the devaluations and resulting inflationary pressures were presumably surprisingly high; on the other, pass-through into prices has been lower than might have been expected (as discussed below). We have used the CPI as the price deflator. Goldfajn and Baig (1998) and Lane et al. (1999) look a variety of other definitions of real interest rates. The choice of deflator does not appear to be critical. An important caveat is that these figures use short-term policy interest rates. Lending rates would generally be substantially higher, though in practice they did not always increase as much as short-term rates, either because of expectations of declines in short rates or market imperfections of various sorts.

46

In the long run, a permanent increase in the risk premium may require a commensurate rise in interest rates to achieve exchange rate stability. If investors demand a higher risk premium, a constant interest rate would result in an overshooting depreciation so that the resulting expectation of appreciation could compensate for the higher risk. But an expectation of appreciation is not consistent with long-run exchange rate stability. Ultimately, then, interest rates have to increase.

47

To the extent that this capital outflow can be accommodated by reserve declines, neither interest rates nor exchange rates need change. Thailand and Korea, for example, did respond to the initial shock through reserve sales rather than interest rate increases or exchange rate declines. This discussion focusses on just interest rate and exchange rate changes partly for simplicity and partly because after the devaluations most of the shock was in fact absorbed through the exchange rate and interest rate, rather than further sales of reserves.

48

Given the differences in policy response and shocks through time, the results will depend to some extent on which date is chosen. I chose March 1998 more-or-less arbitrarily. Footnote 50 notes a case in which this choice matters.

49

Here we again ignore, for simplicity, the loss of reserves as a source of accommodation to the shock.

50

The use of the March 1998 date for comparison exaggerates the lack of interest rate response by the Philippines, which was periodically strong, as Figures 5, 6 and 7 show.

51

We do not see such countries, but it could be argued that the measures of shocks employed are endogenous to the policy response, with tight monetary policy raising sovereign spreads and causing bigger current account swings.

52

The economic impact of these quasi-fiscal deficits was presumably felt when the deficits were incurred before the crisis, not when they were recognized.

53

See Adams et al. (1998), page 50. The division of changes in the fiscal balance into a component due to policy and one due to economic changes is fraught with difficulties. The conclusions drawn here are thus subject to some ambiguity.

54

See Goldfajn and Gupta (1999) for a discussion of the path of the real and nominal exchange rate in a large sample of developing countries following large depreciations.

55

Milesi-Ferretti and Razin (1998) review the experience of a broad sample of countries with rapid current-account reversals. Dornbusch et al. (1995) discuss the aftermath of four external and financial crises, though their focus on episodes of exchange rate overvaluation may be inappropriate in the Asian case.

56

As suggested in Lane et al. (1999).

57

There is little systematic evidence that a credit crunch contributed to the output decline, despite the plausibility of the hypothesis. There are some anecdotal indications that a lack of credit, particularly for working capital, halted otherwise viable economic activity. On the other hand, more systematic evidence comes from Dollar and Hallward-Driemeier (1998), who find that Thai firms put access to credit last on their list of problems in 1997/1998. It is clear that with the crisis came a reevaluation of credit risks that led in some cases to an increase in the spread of risky bank loans over presumably less risky government debt (Ding, Domac and Ferri (1998)). Moreover Domac and Ferri (1998) find that increases in such interest rate spreads precede declines in economic activity in Korea. A flight to quality of bank deposits was also evident in most of the crisis countries. While there was a generalized increase in fear of and assessment of credit risk, the implications for financial sector policy are far from clear. To some extent, an increase in aversion to risk may be a part of the solution, not part of the problem. For example, it is reassuring that, according to Borensztein and Lee (1999b), enterprise profitability is a factor determining the quantity of bank credit obtained in Korea for the first time in 1998. Moreover, Ghosh and Ghosh (1999) find that credit demand fell by more than credit supply at the aggregate level in Indonesia, Korea, and Thailand. See the discussion of the credit crunch hypothesis in Box 10 of Lane et al. (1999), as well as Ito and Pereira da Silva (1998) for an alternate view.

59

Though the World Bank (1998) casts doubt on this explanation.

60

Krueger and Tornell (1999) argue that while overall growth was strong in Mexico, the non-traded sector suffered from the poor functioning of the financial sector.

61

For purposes of dividing the discussion into causes, policy responses and outcomes, the discussion of the run-up ends with the announcement of an IMF agreement in the case of Korea, Indonesia and Thailand, and with the end of the pegged exchange rate regime in the case of Malaysia and the Philippines (which did not have new IMF programs). Only for Indonesia is there an important distinction between the end of the peg and the announcement of the program, with the peg ending in August and the program not announced until October.

62

See Bond and McDermott (1997) for a discussion of the factors behind the export slowdown.

64

Adams et al. (1998) discuss and Baig and Goldfajn (1998) document statistically the importance of contagion in the crisis.

65

This five-fold division comes from and the discussion in this section draws heavily on Adams et al. (1998) as well as various IMF Staff Reports. Baig and Goldfajn (1998) provide a useful chronology of important events.

The Asia Crisis: Causes, Policy Responses, and Outcomes
Author: Mr. Andrew Berg