The Asian Financial Crisis

Charles W.L.Hill

University of Washington


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?
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, Singapore’s by 15% per year, Hong Kong’s 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 Korea’s 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 President’s 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 Bangkok’s 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), Malaysia’s was 5.9%, and Thailand’s 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 Somprasong’s default it became clear that not only were several other property developers teetering on the brink on default; so where many of the country’s financial institutions including Finance One, the country’s 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 country’s 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 One’s 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 didn’t 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 Thailand’s 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 Thailand’s 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 Thailand’s 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 Malaysia’s 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 Malaysia’s 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 Malaysia’s 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 country’s 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 31st 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 Suharto’s 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 Moody’s, the US credit rating agency, feed fuel to this fire when it downgraded Indonesia’s credit rating to junk bond status.

On January 5th 1998 President Suharto seemed to confirm the skepticism of currency traders when he unveiled Indonesia’s 1998-99 budget. The budget immediately came in for criticism because it made optimistic assumptions about Indonesia’s 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 Suharto’s 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 Suharto’s 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 world’s 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 Hanbo’s undoing. Costs for the project escalated from Won 2,700bn to Won 5,700bn while steel demand proved sluggish. Following Hanbo’s 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, Korea’s third largest car company, ran out of cash and asked for an emergency bank loan to avoid bankruptcy. At about the same time Jinaro, Korea’s 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 & Poor’s, the US credit rating agency, immediately downgraded Korea’s 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 country’s 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 nation’s 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, Korea’s short term foreign debt was found to be twice as large as previously thought at close to $100 billion, while the country’s 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 Ssangyong’s 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 IMF’s 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 Korea’s 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 28th, 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 nation’s 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 3rd 1997, when Sanyo Securities, the nation’s seventh largest stock brokerage firm, announced that it would file for bankruptcy. This was followed on November 17th by the collapse of Hokkaido Takushoku, Japan’s 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 Japan’s stock market and property bubble was at its peak, Japan’s 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 Japan’s powerful Ministry of Finance (MOF) to guarantee support for the country’s 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 Japan’s 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 country’s long running recession into a full blown economic depression. A depression in the world’s 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 Yamaichi’s debts. This was followed by a commitment to use public finds to recapitalize Japan’s 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 Japan’s 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 Japan’s 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 (see Chapter 2 for details). 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, Asia’s 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 (see Chapter 10 for details). 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 Korea’s 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 Korea’s 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 macro-economic 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. As outlined in chapter 10 of this book, 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 (see Chapter 10). 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 Kong’s 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 world’s 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 region’s 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 IMF’s 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 Thailand’s 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.