The Asian Financial Crisis

Asian Contagion
Between June 1997 and January 1998 a financial crisis swept like a brush fire through the "tiger
economies" of SE Asian. Over the previous decade the SE Asian states of Thailand, Malaysia,
Singapore, Indonesia, Hong Kong, and South Korea, had registered some of the most impressive
economic growth rates in the world. Their economies had expanded by 6% to 9% per annum
compounded, as measured by Gross Domestic Product. This Asian miracle, however, appeared to come
to an abrupt end in late 1997 when in one country after another, local stock markets and currency
markets imploded. When the dust started to settle in January 1998 the stock markets in many of these
states had lost over 70% of their value, their currencies had depreciated against the US dollar by a
similar amount, and the once proud leaders of these nations had been forced to go cap in hand to the
International Monetary Fund (IMF) to beg for a massive financial assistance. This section explains why
this happen, and explores the possible consequences, both for the world economy, and for international
businesses?
Background
The seeds of the 1997-98 Asian financial crisis were sown during the previous decade when these
countries were experiencing unprecedented economic growth. Although there were and remain
important differences between the individual countries, a number of elements were common too
most. Exports had long been the engine of economic growth in these countries. A combination of
inexpensive and relatively well educated labor, export oriented economies, falling barriers to
international trade, and in some cases such as Malaysia, heavy inward investment by foreign
companies, had combined during the previous quarter of a century to transform many Asian states into
export powerhouses. Over the 1990-1996 period, for example, the value of exports from Malaysia had
grown by 18% per year, Thai exports had grown by 16% per year, Singapores by 15% per year, Hong
Kongs by 14% per year, and those of South Korea and Indonesia by 12% per year. The nature of
these exports had also shifted in recent years from basic materials and products such as textiles
to complex and increasingly high technology products, such as automobiles, semi-conductors,
and consumer electronics.
An Investment Boom. The wealth created by export led growth helped to fuel an investment
boom in commercial and residential property, industrial assets, and infra-structure. The value of
commercial and residential real estate in cities such as Hong Kong and Bangkok started to soar. In
turn, this fed a building boom the likes of which had never been seen before in Asia. Office and
apartment building were going up all over the region. Heavy borrowing from banks financed much of
this construction, but so long as the value of property continued to rise, the banks were more than
happy to lend. As for industrial assets, the continued success of Asian exporters encouraged them to
make ever bolder investments in industrial capacity. This was exemplified most clearly by South
Koreas giant diversified conglomerates, or chaebol, many of which had ambitions to build up a major
position in the global automobile and semi-conductor industries.
An added factor behind the investment boom in most SE Asian economies was the government. In
many cases the government had embarked upon huge infra-structure projects. In Malaysia, for
example, a new government administrative center was been constructed in Putrajaya for M$20 billion
(US$8 billion at the pre July 1997 exchange rate), the government was funding the development of a
massive high technology communications corridor, and the huge Bakun dam, which at a cost of
M$13.6 billion was to be the most expensive power generation scheme in the country.
Throughout the region governments also encouraged private businesses to invest in certain sectors of
the economy in accordance with "national goals" and "industrialization strategy". In South Korea, long
a country where the government played a pro-active role in private sector investments, President Kim
Young-Sam urged the chaebol to invest in new factories. Mr. Kim, a populist politician, took office in
1993 during a mild recession, and promised to boost economic growth by encouraging investment in
export oriented industries. Korea did enjoyed an investment led economic boom in the 1994-95 period,
but at a cost. The chaebol, always reliant on heavy borrowings, built up massive debts that were
equivalent, on average, to four times their equity.

In Malaysia, the government had encouraged strategic investments in the semi-conductor and
automobile industries, "in accordance with the Korean model". One result of this was the national
automobile manufacturer, Perusahaan Otomobil Nasional Bhd, which was established in 1984.
Protected by a 200% import tariff and with few other competitors, the Proton, as the car was dubbed,
sold well in its captive market. By 1989 Perusahaan Otomobil Nasional Bhd was selling 72,000 cars
out of a total market of 117,000. By 1995 it had a 62% share of a market which had grown to 225,000
cars annually. Whether this company could succeed in a competitive marketplace, however, was
another question. Skeptical analysis note that in 1987 an average 1,600cc Proton cost about three times
per capita income in Malaysia; by 1996 a 1,6000cc Proton costs 5.5 times per capita income hardly
what one would expect from an efficient enterprise.
In Indonesia, President Suharato has long supported investments in a network of an estimated 300
businesses that are owned by his family and friends in a system known as "crony capitalism". Many of
these businesses have been granted lucrative monopolies by the President. For example, in 1990 one
the Presidents youngest son, Mr Hutomo, was granted a monopoly on the sale of cloves, which are
mixed with tobacco in the cigarettes preferred by 9 out of 10 smokers in Indonesia. In another example,
in 1995 Suharato announced that he had decided to build a national car, and that the car would be built
by a company owned by Mr Hutomo, in association with Kia motors of South Korea. To support the
venture, a consortium of Indonesian banks was "ordered" by the Government to offer almost $700
million in start-up loans to the company.
In sum, by the mid 1990s SE Asia was in the grips of an unprecedented investment boom, much of it
financed with borrowed money. Between 1990 and 1995 gross domestic investment grew by 16.3%
per annum in Indonesia, 16% per annum in Malaysia, 15.3% in Thailand, and 7.2% per annum in South
Korea. By comparison, investment grew by 4.1% per annum over the same period in the US, and 0.8%
per annum in all high income economies. Moreover, the rate of investment accelerated in 1996. In
Malaysia, for example, spending on investment accounted for a remarkable 43% of GDP in 1996.
Excess Capacity. As might be expected, as the volume of investments ballooned during the 1990s,
often at the bequest of national governments, so the quality of many of these investments declined
significantly. All too often, the investments were made on the basis of projections about future demand
conditions that were unrealistic. The result was the emergence of significant excess capacity.
A case in point were investments made by Korean chaebol in semi-conductor factories. Investments in
such facilities surged in 1994 and 1995 when a temporary global shortage of Dynamic Random Access
Memory chips (DRAMs) led to sharp price increases for this product. However, by 1996 supply
shortages had disappeared and excess capacity was beginning to make itself felt, just as the Koreans
started to bring new DRAM factories on stream. The results were predictable; prices for DRAMs
plunged through the floor and the earnings of Korean DRAM manufacturers fell by 90%, which meant
it was extremely difficult for them to make scheduled payments on the debt they had taken on to build
the extra capacity in the first place.
In another example, a building boom in Thailand resulted in the emergence of excess capacity in
residential and commercial property. By early 1997 it was estimated that there were 365,000 apartment
units unoccupied in Bangkok. With another 100,000 units scheduled to be completed in 1997, it was
clear that years of excess demand in the Thai property market had been replaced by excess supply. By
one estimate, by 1997 Bangkoks building boom had produced enough excess space to meet its
residential and commercial need for at least five years.
The Debt Bomb. By early 1997 what was happening in the Korean semi-conductor industry and the
Bangkok property market was being played out elsewhere in the region. Massive investments in
industrial assets and property had created a situation of excess capacity and plunging prices, while
leaving the companies that had made the investments groaning under huge debt burdens that they were
now finding difficult to service.
To make matters worse, much of the borrowing to fund these investments had been in US dollars,
as opposed to local currencies. At the time this had seemed like a smart move. Throughout the region
local currencies were pegged to the dollar, and interest rates on dollar borrowings were generally lower
than rates on borrowings in domestic currency. Thus, it often made economic sense to borrow in

dollars if the option was available. However, if the governments in the region could not maintain the
dollar peg and their currencies started to depreciate against the dollar, this would increase the size of
the debt burden that local companies would have to service, when measured in the local currency.
Currency depreciation, in other words, would raise borrowing costs and could result in companies
defaulting on their debt payments.
In this regard, a final complicating factor was that by the mid 1990s although exports were still
expanding across the region, so were imports. The investments in infrastructure, industrial
capacity, and commercial real estate were sucking in foreign goods at unprecedented rates. To
build infra-structure, factories, and office buildings, SE Asian countries were purchasing capital
equipment and materials from America, Europe, and Japan. Boeing and Airbus were crowing about the
number of commercial jet aircraft they were selling to Asian airlines. Semi-conductor equipment
companies such as Applied Materials and Lam Materials were boasting about the huge orders they
were receiving from Asia. Motorola, Nokia, and Ericsson were falling over themselves to sell wireless
telecommunications equipment to Asian nations. And companies selling electric power generation
equipment such as ABB and General Electric were booking record orders across the region.
Reflecting growing imports, many SE Asian states saw the current account of their Balance of
Payments shift strongly into the red during the mid 1990s. By 1995 Indonesia was running a current
account deficit that was equivalent to 3.5% of its Gross Domestic Product (GDP), Malaysias was
5.9%, and Thailands was 8.1%. With deficits like these starting to pile up, it was becoming
increasingly difficult for the governments of these countries to maintain the peg of their currencies
against the US dollar. If that peg could not be held, the local currency value of dollar dominated debt
would increase, raising the specter of large scale default on debt service payments. The scene was now
set for a potentially rapid economic meltdown.
Meltdown in Thailand
The Asian meltdown began on February 5th, 1997 in Thailand. That was the date that Somprasong
Land, a Thai property developer, announced that it had failed to make a scheduled $3.1 million interest
payment on an $80 billion eurobond loan, effectively entering into defaulting. Somprasong Land was
the first victim of speculative overbuilding in the Bangkok property market. The Thai stock market had
already declined by 45% since its high in early 1996, primarily on concerns that several property
companies might be forced into bankruptcy. Now one had been. The stock market fell another 2.7% on
the news, but it was only the beginning.
In the aftermath of Somprasongs default it became clear that not only were several other property
developers teetering on the brink on default; so where many of the countrys financial institutions
including Finance One, the countrys largest financial institution. Finance One had pioneered a practice
that had become widespread among Thai institutions --- issuing eurobonds denominated in US dollars
and using the proceeds to finance lending to the countrys booming property developers. In theory, this
practice made sense because Finance One was able to exploit the interest rate differential between
dollar denominated debt and Thai debt (i.e. Finance One borrowed in US dollars at a low interest rate,
and leant in Thai Bhat at high interest rates). The only problem with this financing strategy was that
when the Thai property market began to unravel in 1996 and 1997, the property developers could no
longer payback the cash that they had borrowed from Finance One. In turn, this made it difficult for
Finance One to pay back its creditors. As the effects of over-building became evident in 1996, Finance
Ones non-performing loans doubled, then doubled again in the first quarter of 1997.
In February 1997, trading in the shares of Finance One was suspended while the government tried to
arrange for the troubled company to be acquired by a small Thai bank, in a deal sponsored by the Thai
central bank. It didnt work, and when trading resumed in Finance One shares in may they fell 70% in
a single day. By this time it was clear that bad loans in the Thai property market were swelling daily,
and had risen to over $30 billion. Finance One was bankrupt and it was feared that others would
follow.
It was at this point that currency traders began a concerted attack on the Thai currency, the baht. For
the previous 13 years the Thai baht had been pegged to the US dollar at an exchange rate of around
$1=Bt25. This peg, however, had become increasingly difficult to defend. Currency traders looking at
Thailands growing current account deficit and dollar denominated debt burden, reasoned that demand

for dollars in Thailand would rise while demand for Baht would fall. (Businesses and financial
institutions would be exchanging baht for dollars to service their debt payments and purchase imports).
There were several attempts to force a devaluation of the baht in late 1996 and early 1997. These
speculative attacks typical involved traders selling Baht short in order to profit from a future decline in
the value of the baht against the dollar. In this context, short selling involves a currency trader
borrowing baht from a financial institution and immediately reselling those baht in the foreign
exchange market for dollars. The theory here is that if the value of the baht subsequently falls against
the dollar, then when the trader has to buy the baht back to repay the financial institution it will cost her
less dollars than she received from the initial sale of baht. For example, a trader might borrow Bt100
from a bank for a period of six months. The trader then exchanges the Bt100 for $4 (at an exchange
rate of $1=Bt25). If the exchange rate subsequently declines to $1=Bt50 it will only cost the trader $2
to repurchase the Bt100 in six months and pay back the bank, leaving the trader with a 100% profit! Of
course, since short selling involves selling Baht for dollars, if enough traders engage in this practice, it
can become a self-fulfilling prophecy!
In May 1997 short sellers were swarming over the Thai baht. In an attempt to defend the peg, the Thai
government used its foreign exchange reserves (which were denominated in US dollars) to purchase
Thai baht. It cost the Thai government $5 billion to defend the baht, which reduced its "officially
reported" foreign exchange reserves to a two-year low of $33 billion. In addition, the Thai government
raised key interest rates from 10% to 12.5% to make holding Baht more attractive, but since this also
raised corporate borrowing costs it only served to exacerbate the debt crisis.
What the world financial community did not know at this point, was that with the blessing of his
superiors, a foreign exchange trader at the Thai central bank had locked up most of Thailands foreign
exchange reserves in forward contracts. The reality was that Thailand only had $1.14 billion in
available foreign exchange reserves left to defend the dollar peg. Defending the peg was clearly now
impossible.
On July 2nd, 1997, the Thai government bowed to the inevitable and announced that they would allow
the baht to float freely against the dollar. The baht immediately lost 18% of its value, and started a slide
that would bring the exchange rate down to $1=Bt55 by January 1988. As the baht declined, so the
Thai debt bomb exploded. Put simply, a 50% decline in the value of the baht against the dollar doubled
the amount of baht required to serve the dollar denominated debt commitments taken on by Thai
financial institutions and businesses. This made more bankruptcies such as Finance One all further
pushed down the battered Thai stock market. The Thailand Set stock market index ultimately declined
from 787 in January 1997 to a low of 337 in December of that year, and this on top of a 45% decline in
1996!
On July 28th the Thai government took the next logical step, and called in the International Monetary
Fund (IMF). With its foreign exchange reserves depleted, Thailand lacked the foreign currency needed
to finance its international trade and service debt commitments, and was in desperate need of the
capital the IMF could provide. Moreover, it desperately needed to restore international confidence in its
currency, and needed the credibility associated with gaining access to IMF funds. Without IMF loans,
it was likely that the baht would increase its free-fall against the US dollar, and the whole country
might go into default. IMF loans, however, come with tight strings attached. The IMF agreed to
provide the Thai government with $17.2 billion in loans, but the conditions were restrictive. The IMF
required the Thai government to increase taxes, cut public spending, privatize several state owned
businesses, and raise interest rates all steps designed to cool Thailands overheated economy.
Furthermore, the IMF required Thailand to close illiquid financial institutions. In the event, in
December 1997 the government shut some 56 financial institutions, laying off 16,000 people in the
process, and further deepening the recession that now gripped the country.
The Domino Effect
Following the devaluation of the Thai baht, wave after wave of speculation hit other Asian
currencies. One after another in a period of weeks the Malaysian ringgit, Indonesian rupiah and the
Singapore dollar were all marked sharply lower. With its foreign exchange reserves down to $28
billion, Malaysia let its currency, the ringgit, float on July 14th, 1997. Prior to the devaluation, the
ringgit was trading at $1=2.525 ringgit. Six months later it had declined to $1=4.15 ringgit. Singapore
followed on July 17th, and the Singapore dollar (S$) quickly dropped in value from $1=S$1.495 prior

to the devaluation to $1=S$2.68 a few days later. Next up was Indonesia, whose currency, the Rupiah,
was allowed to float on August 14th. For Indonesia, this was the beginning of a precipitous decline in
the value of its currency, which was to fall from $1=2,4000 Rupiah in August 1997 to $1=10,000 on
January 6th, 1998, a loss of 75%.
With the exception of Singapore, whose economy is probably the most stable in the region, these
devaluations were driven by similar factors to those that underlay the earlier devaluation of the Thai
baht. A combination of excess investment, high borrowings, much of it in dollar denominated debt, and
a deteriorating balance of payments position. The leaders of these countries, however, were not always
quick to acknowledge the home grown nature of their problems.
Malaysia. As the ringgit declined against the US dollar, the Malaysias Prime Minister, Dr. Mahathir
Mohammed, gave speeches asserting that the international financier, George Soros, was the arch villain
in a conspiracy to impoverish Southeast Asian nations by attacking their currencies. According to Dr.
Mahathir, foreign fund managers were selling Malaysian shares because they were racists; currency
traders were ignoring Malaysias sound economic fundamentals; the West was gloating over the crisis
in SE Asia; rumor mongers who "should be shot" were spreading lies and a "Jewish" agenda was at
work against the country. Unfortunately for Dr. Mahathir, every time he gave free rein to his thoughts
on the matter, the Malaysian currency and stock market declined even further. He even tried to outlaw
short selling on the Malaysian stock market, but this too had the opposite effect of that intended, and
the policy had to be pulled shortly after it was introduced.
By Autumn Malaysias government seems to have come around to the view that it needed to put its
own house in order, rather than blame others for its problems. In early September the government
deferred spending on several high profile infra-structure projects including its prestigious Bakun dam
project. This was followed in December 1997 by the release of plans to cut state spending by 18%. The
government also stated that it will not bail out any corporations that become insolvent as a result of
excess borrowing. Then in January 1998, IMF managing director Michel Camdessus, stated that
Malaysia was correct in asserting that it did not need an IMF rescue package to get it through the
regional financial crisis. "Malaysia is not facing a crisis in the same way as some of the other countries
in the region, " he said, noting the authorities have taken measures to deal with the difficulties,
particularly on the fiscal side. On the other hand, he did state that the government needed to raise
interest rates to slow credit growth, moderate inflationary pressures and support the weakening
currency.
Indonesia. Indonesia authorities also initially respond with something less than full commitment to
that countrys financial crisis. Following speculative selling, the Indonesia currency, the rupiah, was
uncoupled from its dollar peg and allowed to float on August 14th, 1997. The rupiah immediately
started to decline, as did the Indonesian stock market. By October the rupiah had dropped from
$1=Rp2,400 in early August to $1=Rp4,000, and the Jakarta stock market index had declined from just
over 700 to under 500. At this point the now desperate Indonesian government turned to the IMF for
financial assistance. After several weeks of intense negotiations, on October 31 st the IMF announced
that in conjunction with the World Bank and the Asian Development Bank it had put together a $37
billion rescue deal for Indonesia. In return, the Indonesian government agreed to close a number of
troubled banks, to reduce public spending, balance the budget, and unravel the crony capitalism that
was so widespread in Indonesia.
The initial response to the IMF deal was favorable, with the rupiah strengthening to $1=Rp3,200.
However, the recovery was short lived. As November lengthened so the rupiah resumed its decline in
response to growing skepticism about President Suhartos willingness to take the tough steps required
by the IMF. Moreover, currency traders wondered how Indonesia was going to be able to deal with its
dollar denominated private sector debt, which stood at $80 billion. With both the economy and
exchange rate collapsing, there was clearly no way that private sector enterprises would be able to
generate the rupiah required to purchase the dollars needed to service the debt, and so the decline feed
on itself. In December Moodys, the US credit rating agency, feed fuel to this fire when it downgraded
Indonesias credit rating to junk bond status.
On January 5th 1998 President Suharto seemed to confirm the skepticism of currency traders when he
unveiled Indonesias 1998-99 budget. The budget immediately came in for criticism because it made

optimistic assumptions about Indonesias economic growth rate in 1998. It projected GDP growth at
4%, inflation contained at single digit levels (in 1997 it was around 20%), and assumed a rupiah-US
dollar exchange rate of $1=Rp4,000 (the rupiah closed 1997 at an exchange rate of $1=Rp5,005).
Moreover, no plans were announced to abolish the lucrative state licensing monopolies that had
benefited his family and friends. An "unnamed" IMF sokesman informed the Washington Post that the
Indonesia government did not seem to be following through on pledges to restructure the economy and
warned that the IMF might hold back funds. International investors and currency traders responded by
selling their rupiah holdings, or selling the rupiah short, and the exchange rate plunged through the
floor, hitting $1=Rp10,000 a few days later.
At this point IMF officials, together with US deputy Treasury Secretary Lawrence Summers, made a
second visit to Jakarta to "re-negotiate" the IMF terms of agreement. On January 15th they reached a
revised agreement which committed Indonesia to a tough budget. Among other things, this pledged
budget cuts, including cuts in sensitive energy subsidies, trade deregulation that would wipe out many
of the business privileges enjoyed by Suhartos family and friends, and accelerated structural reform of
the banking sector.
Whether Suharto will follow through on these commitments, however, remains to be seen. On January
20th the 76 year old President announced his intention to run for a seventh term as President. The
outcome does not seem to be in doubt, since the election in undertaken by hand picked delegates, and
Suharto faces no opponent. The rupiah, meanwhile, which was trading at around $1=Rp8,5000 just
before the announcement, dropped sharply, reaching an all time low of $1=Rp14,500 on January 22nd,
1998 before clawing its way bask up to $1=Rp12,5000.
The sharp drop reflected two concerns. First, fear that Suhartos apparent unwillingness to step down in
the face of an economic collapse may lead to social breakdown and political violence in Indonesia.
Second, growing realization that hundreds of Indonesian businesses were now technically insolvent
and would not be able to pay back the estimated $65 billion of dollar denominated debt they owed
without substantial debt restructuring and rescheduling of the debt payments. The IMF deal, for all of
its good points, had not addressed this critical issue.
South Korea. Initially South Korea seemed to be insolated from the currency turmoil sweeping
through the region. As the worlds 11th largest economy, and a member of the Organization of
Economic Cooperation and Development, Korea was clearly in a different league from Thailand,
Indonesia, and Malaysia. However, underneath the surface Korea too had serious problems
During much of the 1990s foreign banks had been eager to lend US dollars to Korean Banks and the
chaebol. A significant proportion of this was short term debt that had to be paid back within a year.
This money was used to fund investments in industrial capacity, which as suggested earlier, were
often undertaken at the encouragement of the government. By late 1996 it was clear that the debt
financed expansion was beginning to unravel. Economic growth had slowed, excess capacity was
emerging in a number of industries, prices for critical industrial products such as semi-conductors were
falling, and imports were on the rise (Korea ran a current account deficit of $23.7 billion in 1996).
The Korean debt problem started to deteriorate in January 1997 when one of the chaebol, Hanbo
collapsed under a $6 billion debt load. A 1993 decision to build the world's fifth largest steel mill
proved to be Hanbos undoing. Costs for the project escalated from Won 2,700bn to Won 5,700bn
while steel demand proved sluggish. Following Hanbos collapse there were widespread allegations in
Korea that the project had been funded only because of the government pressured Korean banks to lend
to Hanbo. Moreover, allegations soon surfaced that government officials had been bribed by Hanbo to
pressure the banks.
The situation deteriorated further in July 1997 when Kia, Koreas third largest car company, ran out of
cash and asked for an emergency bank loan to avoid bankruptcy. At about the same time Jinaro,
Koreas largest liquor group, filed for bankruptcy. These events prompted international credit agencies
to start downgrading the ratings of banks with heavy exposure to the chaebol. This raised the
borrowing costs of the banks, and led them to tighten credit, making it even more difficult for debt
heavy chaebol to borrow additional funds. By October 1997 it was clear that additional funds for Kia
would not be forthcoming from private banks, so the government took the company into public

ownership in order to stave off bankruptcy and job losses. This followed hard on the heels of a decision
by the Korean government to invest an equity stake in Korea First Bank, to stop that institution from
collapsing due to a its bad loans. The nationalization of Kia transformed its private sector debt into
public sector debt. Standard & Poors, the US credit rating agency, immediately downgraded Koreas
debt, causing the Korean stock market to plunge 5.5%, and the currency, the Korean won, to fall to
$1=Krw929.5. According to S&P, "the downgrade of..ratings reflects the escalating cost to the
government of supporting the country's ailing corporate and financial sectors."
The S&P downgrade was the trigger that precipitated a sharp sell-off of the Korean won. In an attempt
to protect the won, the Korean central bank raised short term interest rates to over 12%, more than
double the inflation rate. The bank also intervened in the currency exchange markets, selling dollars
and purchasing won in an attempt to keep the dollar/won exchange rate above $1=Krw1,000. The main
effect of this action, however, was to rapidly deplete its foreign exchange reserves. These stood at $30
billion on November 1st, but fell to only $15 billion two weeks later.
To make matters worse, the wave of bankruptcies continued among the chaebol. Haitai, Korea's 24th
largest business, filed for bankruptcy protection at the beginning of November, and rumors suggests
that New Core, another chaebol would soon follow. This meant that one-fifth of the countrys thirty
largest businesses had now filed for bankruptcy protection. Moreover, there was speculation that as
many as half of the top 30 chaebol might ultimately have to file for bankruptcy. International lenders,
fearing that Korea was about to become a financial black whole, refused to roll over short-term loans to
the country, an action made all the more serious by revelations that Korea had about $100 billion in
short term debt obligations that had to be paid within 12 months.
With Korea facing imminent financial meltdown, the prospect of an IMF led bailout of the country was
being openly discussed. On November 13th, the Korean government declared that it "did not need help
from the IMF", apparently believing that it would be able to arrange bilateral loans from the US and
Japan. They were not forthcoming, and on November 17th, with the nations foreign exchange reserves
almost exhausted, the Korean Central bank gave up its defense of the won. The won immediately fell
below the psychologically important $1=Krw1,000 exchange rate, and it kept going south. On
November 21st the now humiliated Korean government was forced to reverse course and formally
requested $20 billion in standby loans from the IMF.
The process was complicated considerably at this point by the fact that Korea was facing a presidential
election campaign on December 18th. The IMF, therefore, had to negotiate terms with a lame duck
President, Kim Young-sam, who has required to step down by the constitution, while the three main
candidates criticized the process from the sidelines. As the negotiations progressed, it soon became
apparent that Korea was going to need far more than $20 billion. Among other problems, Koreas short
term foreign debt was found to be twice as large as previously thought at close to $100 billion, while
the countrys foreign exchange reserves were down to under $6 billion.
On December 3rd the IMF and Korean government reached a deal to lend $55 billion to the country.
The IMF had tried to insist that all three Presidential candidates promise, in writing, to obey the
agreement. However, Kim Dae-jung, the centre-left opposition leader, said he would refuse to sign any
guarantee with the IMF because "it violated national pride," although he did signal general compliance
with the measures. The agreement with the IMF called for the Koreans to open up their economy and
banking system to foreign investors. Prior to the deal foreigners could only own 7% of a Korean
company's shares. This was lifted to 50%. South Korea also pledged to restrain the chaebol by reducing
their share of bank financing and requiring them to publish consolidated financial statements and
undergo annual independent external audits. On trade liberalization, the IMF said South Korea will
comply with its commitments to the World Trade Organization to eliminate trade-related subsidies and
restrictive import licensing, and streamline its import- certification procedures, all of which should
open up the Korean economy to greater foreign competition.
Initial reaction in the stock and currency markets was very favorable, with the Korean stock marketing
registering a 7% gain, its biggest one day advance ever. However, the package started to unravel on
December 8th when the Korean government said that it would take two trouble banks into public
ownership, rather than closing them. On the same day, Daewoo, one of the chaebol, announced that it
would purchase debt laden Ssangyong Motor under a deal that forced Ssangyongs creditor banks to

share much of the burden. Foreign investors saw these moves as an attempt to get around the harsh
measures imposed by the IMF. Further compounding matters were criticisms from presidential
candidate Kim Dae-jung. Kim argued that the IMF agreement represented a loss of national
sovereignty and he promised that, if elected, he would renegotiate the deal to avoid job losses. In
response to these developments, foreign banks refused to roll over short term loans investors sold out
of the Korean stock market and won, and both dropped like stones. The won began a precipitous fall
that was to take it down to the 2,000 level in two short weeks, a decline that effectively doubled the
amount of won Korean companies would have to earn to finance their dollar denominated debt. By mid
December foreign banks were only rolling over 20-30% of Korean short term debt as it matured,
requiring that the rest be paid in full. Despite the IMF funds, foreign currency was leaving the country
at the rate of $1 billion a day.
Following pressure from the other presidential candidates, Kim Dae-jung, reversed his position and
sent a letter to Michael Camdessus, the head of the IMF, stating that if elected, he would comply with
the IMFs terms. On December 18th, Kim Dae-jung was elected president of South Korea by a narrow
margin. He immediately turned his attention to the debt crisis. His attention was heightened by the
uncomfortable fact that Korea was on the verge of default. His first priority was to rebuild confidence
and persuade foreign banks to roll over Korean short term debt, thereby staving off an immediate
default. The international community was also concerned by the possibility that a Korean default
would trigger a banking crisis in Japan, which held $25 billion of Korean debt, an event that would
send economic shock waves surging around the world.
In the event, a second agreement was reached between Korea, the IMF, and a number of major
American and British banks with large exposure to Korea. Singed on Christmas Eve, the agreement
called for the IMF and eight major banks to accelerate a loan of $10 billion to Korea to prevent a debt
default. For his part, Kim Dae-jung spelled out in clear language that Korean businesses and jobs could
no longer be protected from foreign competition. Korea also agreed to an accelerated timetable for
opening up its financial markets to foreign investors, permitting foreign takeovers, and allowing
foreign companies to establish subsidiaries in Korea. The government also agreed to raise interest rates
in order to attract foreign capital, force the chaebol to restructure their operations, selling-off loss
making units and demanding clearer accounting. If the government follows through with these reforms,
the effect could be to transform Koreas economy from one in which the government plaid a major role
in regulating and directing investment activity into one of the most market-oriented economies in Asia.
In response, for now Korean stock and currency markets have stabilized, but it would be naive to
expect anything approaching a full recovery until the country has put its house in order.
The situation in South Korea improved still further on January 28 th, 1998 when a consortium of 13
international banks with exposure to Korea agreed to reschedule their short term debt to Korea.
According to the Bank for International Settlements, In early 1998 South Korea was sitting on $74
billion in debt that was coming due for repayment in the next two years. This added up to a cash flow
squeeze of major proportions that the earlier IMF deal had fully come to grips with. Under the plan
South Korean banks will exchange short term debt valued at $24 billion for new loans with maturities
of one, two, and three years, bearing interest rates of 2.23, 2.50, and 2.75 percentage points higher than
the six month London Interbank rate. By effectively rescheduling so much of its short term debt, the
deal gave South Korea some breathing room in which it could begin to rebuild confidence in its
shattered economy.
Japan. As the crisis unfolded, most Japanese felt that it had little to do with them. At worst, there
was some concerns that the turmoil might harm some of the nations exporters. Indeed, the main issue
for debate was whether Japan should take a leadership role in handling the crisis. This sense of
insulation was always rather myopic given that Japanese banks had major exposure throughout Asia.
For example, more than half of the total foreign lending to Thailand was by Japanese Banks. The
possibility always existed, therefore, that a collapse in many of the SE Asian economies could have
serious repercussions for Japan.
The confidence of the Japanese was finally shaken on November the 3 rd 1997, when Sanyo Securities,
the nations seventh largest stock brokerage firm, announced that it would file for bankruptcy. This was
followed on November 17th by the collapse of Hokkaido Takushoku, Japans 10th largest bank, and on
November 22nd, by the announcement that Yamaichi Securities, the fourth largest stock-broker in

Japan, would close its doors. The Japanese stock market fell on the news to its lowest level in years,
and for a moment it looked like the Asian financial crisis might spill over into Japan.
The closure of these three institutions dated back to events almost a decade earlier. In the late 1980s
when Japans stock market and property bubble was at its peak, Japans financial institutions went on a
lending binge. In 1989 the Nikki stock market index briefly rose to within striking distance of 40,000
before the bubble burst and the market fell to 15,000 three years later. Following the collapse of stock
and property prices in Japan, many of the loans made in the bubble years became non-performing.
They were, however, kept on the books for years as performing loans, often with the tacit support of
the Bank of Japan, in hopes that the companies involved would work their way out of financial
difficulties. Moreover, many financial institutions held a good portion of their asset in stock. With the
collapse in the value of the Japanese stock market, the value of these assets had also plummeted,
leaving the institutions with a diminished asset base and an increased portfolio of non-performing
loans. To compound matters even further, security houses such as Yamaichi frequently guaranteed
major customers a certain minimum rate of return on and investments they managed for the customer,
and would make up the difference from their own pocket if they failed to exceed that minimum. In the
years that followed the 1989 collapse, this meant that Yamaichi and its kin had to absorb losses
associated with business taken on at the height of the boom. The securities houses also indulged in the
questionable practice of tobashi in which brokerages temporarily shift investment losses from one
client to another to prevent a favored customer from having to report losses.
There is only so long that a bank or security house can continue to undertake such practices without an
improvement in their underlying fundamentals. After eight years of recession, in late 1997 that time
had arrived for Sanyo Securities, Hokkaido Takushoku, and Yamaichi Securities. All three were
sinking under the burden of excessive debt and non-performing loans. That all three had survived this
long was a testament to the willingness of Japans powerful Ministry of Finance (MOF) to guarantee
support for the countrys shaky financial institutions. That all three collapsed in late 1997 signaled a
clear change of course by the Ministry of Finance.
Exactly why the MOF decided to change course is not completely clear. Some speculate that the MOF
wanted a "shock" of this sort to persuade politicians and the public to use public funds to help bail out
Japans troubled financial sector (up until this point there had been widespread resistance to using
public funds for this purpose). Another factor in the Yamaichi case was that Fuji Bank, the traditional
ally of the securities firm, finally withdrew its support. In any event, the result was to send the Japanese
stock market into a steep fall. With investors fearing that more bankruptcies might follow, the Nikki
Index declined from 17,000 to close to 14,500. The 14,000 level is particularly significant in Japan,
where financial institutions hold assets in the form of stock. If the Nikki falls below 14,000, many
financial institutions will not have enough assets on their books to cover their liabilities, and they will
have to sell stock to reduce the ratio. Once this happens, the Japanese market could implode,
transforming the countrys long running recession into a full blown economic depression. A depression
in the worlds second largest economy would have disastrous implications for the health of the global
economic system.
It was at this point that Japanese government stepped in with the announcement that it planned to use
public funds to guarantee Yamaichis debts. This was followed by a commitment to use public finds to
recapitalize Japans troubled financial institutions. By January 1998 the amount of public funds
earmarked for this task had reached Y30,000 billion (around $230 billion). This commitment helped to
stabilize Japans stock market, and the country pulled back from the brink of financial meltdown. The
commitment of public funds also illustrate the difference between Japan and the other Asian countries
afflicted by financial crises. Unlike the troubled Tiger economies, Japan had amassed a huge amount of
reserves that could be used shore up its trouble financial system.
Although Japan did not suffer the fate of other Asian countries, the problems in Japan did have an
impact on the situation, for it considerably weakened Japans ability to step in and take a lead roll in
solving the wider Asian debacle. Instead of Japan, its was left to the IMF, in conjunction with the
United States, to step in and stop the free fall in Asian stock markets and currencies. The credibility of
Japan both as a source of stability within the region, and as the de-facto economic leader of the Asia
Pacific economies, has been severely and perhaps permanently damaged by its inability to take a
leadership role in solving the crisis.

Aftermath: Implications of the Crisis.

Although the economic storm that swept through Asian in 1997 has now abated, the wreckage left in its
wake will undoubtedly take years to repair. By indulging in a debt binge that ultimately bought its high
flying economies crashing to the ground, Asia may have lost a decade of economic progress. Beyond
this, however, the crisis has raised a series of fundamental policy questions about the sustainability of
the so called Asian Economic Model, the role of the IMF, and the virtues of floating and fixed
exchange rates. The crisis also has important implications for international businesses. For a decade,
the Asian Pacific region has been promoted by many as the future economic engine of the world
economy. Businesses have invested billions of dollars in the region on the assumption that the rapid
growth of the last decade would continue. Now it has come grinding to a halt. What does this mean for
international businesses with a stake in the region, and for those that compete against Asian
companies? Below we discuss each of these questions in turn.
The Asian Economic Model. Back in the late 1980s and early 1990s a number of authors were
penning articles about the superiority of the Asian Economic Model or Asian Capitalism. According to
its advocates, the countries of the Asian Pacific region, as exemplified by Japan and South Korea, had
put together the institutions of capitalism in a more effective way than either the United States or
Western European nations. The so called Asian Model of state directed capitalism seemed to combine
the dynamism of a market economy with the advantages of centralized government planning. It was
argued that close cooperation between government and business to formulate industrial policy led to
the kind of long-term planning and investment that was not possible in the West. Informal lending
practices were credited with giving Asian firms more flexibility than allowed for by the rigorous
disclosure rules imposed on similar transactions in the United States. And Western admirers praised
government policies designed to encourage exports and protect domestic producers from imports.
However, economists have argued for some time that the Asian economic miracle had nothing to
do with cooperation between government and business. Instead, it was the result of high savings
rates, good education systems, and rapid growth in the labor force. Many warned that the Asian
proclivity for government directed investment and poorly regulated financial systems was a dangerous
mix that could lead to over investment, excessive debt, and financial crises. Despite the occurrence of
just such a crisis in Japan in 1989, advocates of the Asian Way, including many leading politicians in
Asia, steadfastly ignored the risks inherent in an interventionist economic model. Instead, they
continued to sing the praises of business-government cooperation and "Confucian values", right up to
the explosion of the debt bomb and the collapse of their stock markets and currencies in late 1997.
Now that the crash has occurred, momentum in Asia is starting to shift away from the "Asian Way"
and towards the Western economic model. Pushed in part by the IMF, but also by shifting opinion
among some politicians and business leaders within the region, Asias troubled economies seem to be
embarking on a long overdue restructuring. Governments are pulling back from close cooperation with
businesses, financial disclosure regulations are being tightened, troubled banks and companies have
been allowed to fail, and markets are being deregulated to allow for greater competition and foreign
direct investment. As a consequence, it seems reasonable predict that many Asian economies will come
to resemble, more closely, the free market system championed by the United States than the Asian
model exemplified by the Japan of the 1980s.
The International Monetary Fund. The Asian financial crisis has been the biggest test for the IMF
since the Latin American debt crisis of the 1980s, and perhaps the biggest test since the institution was
founded in 1944. The original charge of the IMF was to lend money to member countries that were
experiencing balance of payments problems, and could not maintain the value of their currencies. The
idea was that the IMF would provide short term financial loans to troubled countries, giving them time
to put their economies in order. IMF loans have always came with strings attached. In the past, most
recipients of IMF aid have suffered from excessive government spending, lax monetary policy and
high inflation. Consequently, conditions attached to IMF loans have normally required the borrowing
country to slash government spending and raise interest rates to slow monetary growth and inflation.
As a result of the Asian crisis, in late 1997 the IMF found itself committing over $110 billion in short
term loans to three countries; South Korea, Indonesia, and Thailand. To put this in perspective, the
largest loan prior to this was the $48 billion package that the IMF gave to Mexico in 1995 following
the collapse of the Mexican peso. As with other aid packages, the IMF loans come with conditions

attached. The IMF is insisting on a combination of tight macro-economic policies, including cuts in
public spending and higher interest rates, the deregulation of sectors formally protected from domestic
and foreign competition, and better financial reporting from the banking sector. Although politicians in
each country initially resisted these conditions, they ultimately accepted them and so far at least, seem
to be pursuing them. Despite the acquiescence of local politicians, the IMF policies towards Asian
countries have come in for unusually tough criticisms from many Western observers.
One criticism is that tight macro-economic policies are inappropriate for countries that are suffering not
from excessive government spending and inflation, but from a private sector debt crisis with
deflationary undertones. In Korea, for example, the government has been running a budget surplus for
years (it was 4% of Koreas GDP in the 1994-1996 period) and inflation is low at around 5%. Indeed,
Korea has the second strongest financial position of any country in the Organization for Economic
Cooperation and Development. Despite this, say critics, the IMF is insisting on applying the same
policies that it applies to countries suffering from high inflation. The IMF is requiring Korea to
maintain an inflation rate of 5%. However, given the collapse in the value of its currency, and the
subsequent rise in price for imports such as oil, inflationary pressures will inevitably increase in Korea.
So to hit a 5% inflation rate, the Koreans are being forced to apply an unnecessarily tight monetary
policy. Short term interest rates in Korea jumped from 12.5% to 21% immediately after Korea signed
its initial deal with the IMF. The essential problem here is that increasing interest rates make it even
more difficult for Korean companies to service their already excessive short term debt obligations; that
is, the cure prescribed by the IMF may actually increase the probability of widespread corporate
defaults in Korea, not reduce them.
For its part, the IMF rejects this criticism. According to the IMF, the critical task is to rebuild
confidence in the Korean currency, the won. Once this has been achieved, the won will recover from its
extremely oversold levels. This will reduce the size of Koreas dollar denominate debt burden when
expressed in won, in turn making it easier for Korean companies to service their dollar denominated
debt. The IMF also argues that by requiring Korea to remove restrictions on foreign direct investment,
foreign capital will flow into Korea to take advantage of cheap assets. This too, will increase demand
for the Korean currency, and help to improve the dollar/won exchange rate.
A second criticism of the IMF is that its rescue efforts are exacerbating a problem know to economists
as moral hazard. Moral hazard arises when people behave recklessly because they know they will be
saved if things go wrong. In the case of Asia, critics point out that many Japanese and Western banks
were far too willing to lend large amounts of capital to over-leveraged Asian companies during the
boom years of the 1990s. These critics argue that the banks should now be forced to pay the price for
their rash lending policies, even if that means some banks must shut down. Only by taking such drastic
action, so the argument goes, will banks learn the error of their ways and not engage in rash lending in
the future. By providing support to these countries, the IMF is reducing the probability of debt default,
and in effect bailing out the very banks whose loans gave rise to this situation in the first place.
The problem with this argument is that it ignores two critical points. First, if some Japanese or Western
banks with heavy exposure to the troubled Asian economies were forced to write off their loans due to
widespread debt default, this would have an impact that would be difficult to contain. The failure of
large Japanese banks, for example, could trigger a meltdown in the Japanese financial markets. In turn,
this would almost inevitably lead to a serious decline in stock markets around the world. That is the
very risk that the IMF was trying to avoid in the first place by stepping in with financial support.
Second, it is incorrect to imply that some banks have not had to pay the price for rash lending policies.
In fact, the IMF has insisted on the closure of banks in Korea, Thailand and Indonesia. Moreover,
foreign banks with short term-loans outstanding to Korean enterprises have been essentially forced by
circumstances to reschedule those loans at interest rates that do not compensate for the extension of the
loan maturity.
The final criticism of the IMF is that is has become too powerful for an institution that lacks any real
mechanism for accountability. By the end of 1997, the IMF was engaged in loan programs in 75
developing countries that collectively contain 1.4 billion people. The IMF was determining macroeconomic policies in those countries, yet according to critics such as noted Harvard economist Jeffery
Sachs, with a staff of under 1,000 the IMF lacks the in-depth expertise required to do a good job.
Evidence of this, according to Sachs, can be found in the fact that the IMF was singing the praises of

the Thai and South Korean governments only months before both countries lurched into crisis. Then
the IMF put together a draconian program for Korea without having deep knowledge of the country.
Sachs solution to this problem is to reform the IMF, so that it makes greater use of outside experts, and
so that its operations are open to great outside review and scrutiny.
Implications for Exchange Rate Policy There is a long running debate in international business and
economics between those who favor fixed exchange rate mechanisms, and those who favor a floating
system. Since the collapse of the Bretton Woods fixed exchange rate system in 1973, the world has
functioned with a floating exchange rate system However, there are variations to this theme. Most
Asian countries tried to peg the value of their currency against the US dollar, intervening selectively in
the foreign exchange markets to support the value of their currency. This practice, know as a managed
float, is an attempt to achieve some of the benefits associated with a fixed exchange rate regime in a
world of that lacks such a regime. Critics argue that such a policy is vulnerable to speculative pressure.
The events that unfolded in the fall of 1997 have given the critics additional ammunition. The value of
the Korean, Indonesia, Thai, and Malaysian currencies did not just decline against the dollar, they
collapsed in spectacular fashion, illustrating the sometimes extreme results of speculative attacks on a
currency in a world of floating exchange rates.
The experience of Hong Kong during the crisis, however, has added a new dimension to the debate.
Hong Kong was able to maintain the value of its currency against the US dollar at around $1=HK$7.8,
despite several concerted speculative attacks. How did it manage to do this? One answer that has been
offered is that Hong Kong operates with a currency board. A country that introduces a currency board
commits itself to converting its domestic currency on demand into another currency at a fixed
exchange rate. To make this commitment credible, the currency board holds reserves of foreign
currency equal at the fixed exchange rate to at least 100% of the domestic currency issued. So for
example, the system used in Hong Kong means that its currency must be fully backed by the US dollar
at the specified exchange rate. Of course, this is not a true fixed exchange rate regime, since the US
dollar, and by extension the Hong Kong dollar, floats against other currencies, but it does has some of
the features of a fixed exchange rate regime.
Under this arrangement, the currency board can only issue additional domestic notes and coins when
there are foreign exchange reserves to back it. This limits the ability of the government to print money
and, thereby, create inflationary pressures. Under a strict currency board system, interest rates adjust
automatically. If investors want to switch out of domestic currency into, for example, US dollars, the
supply of domestic currency will shrink. This will cause interest rates to rise until it eventually
becomes attractive for investors to hold the local currency again. In the case of Hong Kong, the interest
rate on 3 month depots climbed as high as 20% in late 1997, as investors switched out of Hong Kong
dollars and into US dollars. The dollar peg, however, held and interest rates declined again.
Since its establishment in 1983, the Hong Kong currency board has weathered several storms,
including the latest. This success seems to be persuading other countries in the developing world to
consider a similar system. Argentina introduced a currency board in 1991, and Bulgaria, Estonia and
Lithuania have all gone down this road in recent years. Despite growing interest in the arrangement,
however, critics are quick to point out that currency boards have their drawbacks. If local inflation rates
remain higher than the inflation rate in the country to which the currency is pegged, the currencies of
countries with currency boards can become uncompetitive and overvalued. Moreover, under a currency
board system government lacks the ability to set interest rates. Interest rates in Hong Kong, for
example, are effectively set by the American Federal Reserve. Despite these drawbacks, however,
Hong Kongs success in avoiding the currency collapse that afflicted its Asian neighbors suggests that
other developing countries may adopt a similar system in the future.
Implications for Business. The Asian financial crisis throws the risks associated with doing business
in developing countries into sharp focus. For most of the 1990s, multinational companies have viewed
Asia as a future economic powerhouse, and invested accordingly. This view was not without
foundation. The region is home to 60% of the worlds people and a number of dynamic economies that
have been growing by nearly 10% per year for most of the past decade. This euphoric view was rudely
shattered by the events of late 1997. It would be wrong to conclude, however, that the impact upon
companies doing business in the region will be purely negative. On closer examination, there is a silver
lining to many of the storm clouds hanging over Asia.

On the negative side on the equation, the Asian crisis will undoubtedly have some painful effects on
companies with major activities and investments in the regions troubled economies. For example,
when the Malaysian government cancelled its $5 billion Bakun hydro-electric damn project this hurt
ABB, the large European based engineering firm that was a prime contractor on the project. ABB took
a $100 million charge and the Asian slowdown helped to trigger job cuts totaling 10,000 in many of its
European facilities. Similarly, Boeing expressed concern that the Asian crisis may result in as many as
60 orders for large jet aircraft being postponed or cancelled.
To make matters worse, many Asian companies will now be looking to export their way out of
recessionary conditions in their home markets. This may lead to a flood of low priced exports from
troubled Asia economies to other countries. United States and European steel companies, for example,
are bracing themselves to deal with the adverse impact on demand and prices in their home market of
an increased in the supply of low cost steel from South Korea. The fall in the value of the Korean won
against the dollar has given Korean steel companies a competitive edge in global markets that they
lacked just six months ago.
On the other hand, firms that source components from Asia have seen a steep drop in the price of those
inputs, which has a beneficial impact on profit margins. For example, Dell Computer, the large US
based manufacturer of personal computers, has seen a 50% drop in the price of certain components
such as memory chips that it buys from Asian manufacturers. Similarly, even though ABB took a hit
when it lost the Bakun Dam project, the company argues that this will be more than off-set over the
next few years by increases in exports from its own factories based in that region.
Furthermore, several firms are reportedly taking advantage of the changing circumstances in Asia to
increase their rate of investment in the region. Plunging stock markets across the region have left many
Asian companies trading at prices that are less than their break-up value, while the IMFs rescue
packages have required Korea, Indonesia, and Thailand to relax restrictions on inward foreign direct
investment. As a result of these factors, it is reasonable to expect firms from outside of these countries
to start buying the assets of troubled companies while they can be purchased for cents on the dollar.
Indeed, there are signs that that is starting to happen. In December 1997, for example, Citicorp was
reported to be examining the books of Thailands seventh largest bank, First Bangkok City Bank, with
a view to making an acquisition. Citicorp was also reported to be looking for acquisitions in South
Korea
Finally, it is worth emphasizing that despite its dramatic impact, the long run effects of the crisis may
be good not bad. To the extent that the crisis gives Asian countries an incentive to reform their
economic systems, and to initiate some much need restructuring, they may emerge from the experience
not weaker, but stronger institutions and a greater ability to attain sustainable economic growth.

Questions
1.

2.

Explain how the above excerpt on the Asian financial crisis of the 90s validates the trilemma of
international finance. The Impossible Trinity (also known as the Inconsistent Trinity, Triangle of
Impossibility or Unholy Trinity) is the Trilemma in international economics suggesting it is impossible
to have all three of the following at the same time:
A fixed exchange rate.
Free capital movement (absence of capital controls).
An independent monetary policy
Discuss, in your opinion, does the Asian financial crisis negate or support the need of an organization
such as the IMF.