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The Asian Financial Crisis Remembered: Ten Years Wiser

Ten years ago on July 2, Thailand decided to float its currency, the baht, triggering the  region-wide chain reaction known as the Asian Financial Crisis. In less than six months, the U.S. dollar more than doubled in value against the baht. As the baht plunged in value, Thailand's stock market took a massive beating.

Other currencies and stock markets in the region also suffered, sending newly industrialized economies of Asia – in particular Indonesia, Malaysia, South Korea and Thailand – into a tailspin over the next two years.   

Thailand’s stock market shed over three-quarters of its value by the end 1997, as did those in Malaysia and Indonesia.  South Korea fared slightly better, but still fell 70%.

One after another, like dominoes stacked in a row, currencies in the region that had previously been pegged against the dollar (with the exception of the Malaysian ringgit) succumbed to market forces.  August saw the Indonesian rupiah’s managed float replaced by a free-floating rate.  The South Korean won was floated on Christmas Eve that year.  Malaysia went the opposite way, instituting capital controls in September 1998, fixing the ringgit at 3.8 to the dollar. These controls were only lifted in 2005. 

For the hardest hit countries of Indonesia, South Korea and Thailand, it was a baptism by fire, but the crisis – which quickly earned the catchy moniker "Asian Contagion" – had much wider repercussions and highlighted the tight-knit nature of global markets. 

When the South Korean stock market fell 11% one day, so-called circuit breakers were triggered on the New York Stock Exchange, forcing a halt to trading before the official closing time.  Later on, among other things, Asian Contagion was given partial blame for the collapse of the U.S. hedge fund Long Term Capital Management as well as the Russian debt crisis in 1998.

Who would have thought that a run on the Thai baht could have triggered a regional cataclysm that also reverberated through the world?  

Roots Of The Crisis

Even with a decade’s worth of hindsight, experts are still at odds over the causes of the crisis. What we do know is this:

During the years preceding the crisis, regional economies experienced rapid growth that attracted large amounts of foreign investment in the form of foreign debt financing.  Marc Chandler, global head of currency strategy at Brown Brothers Harriman, says that during this period of boom in the early 1990s, the system of fixed exchanges and managed floats gave people a false sense of comfort and encouraged poor investment decisions.  The implicit guarantee against exchange rate risk very comfortably facilitated international trade and foreign debt financing, which in turn, supported high and sustained growth in many countries. 

The strong and sustained economic growth and subsequent wealth created led to a huge demand for property, which in turn led to oversupply.  The abundant foreign debt financing that flowed into Asian economies and into real estate development was aggravated by very poor due diligence on the part of banks and financial institutions, loose private credit and the lack of corporate governance.  In short, banks were not lending wisely to the private sector, which had turned a blind eye to corporate governance, something Chandler likens it to a World Cup game without referees. 

  *International Monetary Fund

Crisis Pays Off

Countries, flush with foreign capital, bought and borrowed more and more, creating yawning current account deficits in the mid-1990s.  David Cohen, director of Asian economic forecasting at Action Economics, believes that the basic equilibrium was maintained for as long as foreign investment flows were smooth and currencies were strong.  When that came to an abrupt end in July 1997, the pullout of foreign investment was inevitable, swift and vicious.  And with capital flight, currencies and current account deficits came under great pressure. The rest is history.

Payoff To Punishment

Ten years after the crisis, Asia is all the wiser for it.  Among the key lessons of the financial crisis – the importance of liquidity and risk management; the need for enforceable regulations (the referees in a soccer match if you will); and the knowledge that economic integration can make countries more resilient to crisis. 

Indonesia, Malaysia, South Korea and Thailand are now all running current account surpluses, creating, in effect, huge war chests of foreign currency reserves that act as an insurance policy against financial shocks.  The external positions of these countries are in far better shape than a decade ago.

Measures to deal with immediate or sudden strains to the financial system are in place, as are mechanisms to facilitate financial restructuring. Regulatory frameworks have been upgraded and corporate governance strengthened.

Through vigorous restructuring throughout all affected countries, nonperforming loans at banks have been brought down to more manageable levels. There is more to be done, but on the whole, the International Monetary Fund believes Asian countries have regained their footing. 

The center of economic gravity is also slowly, but surely shifting away from the U.S. and other western industrialized countries, to China.  The Chiang Mai network of bilateral swap lines among Asian central banks (including China) is now in the process of being converted into a reserve pooling arrangement. The Asian Bond Fund is yet another example of pan-Asian economic integration.

Deja Vu All Over Again?

The irony is that today, a decade later, the very same countries affected by the crisis are the ones contributing to the growing U.S. current account deficit.  Nicholas Carn, a partner at Odey Asset Management notes, "Countries that have built up large foreign currency reserves and run chronic surpluses create a different set of issues."

China's economic growth rate has been in double-digit territory since early 2005 and that growth is export-led, which has led to a ballooning trade surplus with the U.S.

China and Korea, to name just two, have let most of their export proceeds (billions of U.S. dollars) rest comfortably as reserves in their central banks or have used them to buy U.S. Treasuries. This helps support the value of the dollar, and by extension, other U.S. financial instruments and assets.

But some say that if another financial crisis were to emerge, the country most vulnerable would be the United States. "At some point if the Chinese pull out, the U.S. dollar would come under attack," says Marc Chandler of Brown Brothers Harriman.

Although that scenario may be extremely unlikely, it is a concern that hits the markets from time to time -- causing selloffs of varying magnitude -- and serves as a reminder that what goes around comes around, even in the global markets.