The Asian Financial Crisis 20 Years On

If we looked only at the economic data, it is not clear why we would revisit the Asian financial crisis 20 years out. Although the trouble started earlier, the affected economies did not begin to contract until the first quarter of 1998, and growth rates had turned positive by mid-1999.

What made the Asian financial crisis such a shock was the previous success of its victims and their apparent conformity with economic orthodoxy. The developing world had seen financial crises before, particularly a wave beginning in 1983 triggered by the second oil shock: Mexico Brazil, and Argentina, spreading to the Philippines, Poland, Turkey, and a number of low-income African countries. The early crisis countries had in common not only fixed exchange rates, but a commitment to import-substituting development strategies. Protection and overvalued exchange rates generated recurrent balance of payments problems. Euromarket lending was seen as financing profligate public sectors if not populism and outright corruption.

The East Asian countries shared some of these disabilities, most notably fixed exchange rates. But over the 1960s and 1970s, Japan, then South Korea, Taiwan, Hong Kong, and Singapore, along with enclaves such as Penang in Malaysia, became poster children for export-oriented growth strategies. Trade policy was by no means laissez-faire, but complex systems of tariff exemptions and aggressive exchange rate policy made for highly competitive economies exploiting comparative advantage in labor-intensive activities. Observed fiscal deficits were also moderate by virtually any standard.

In a controversial report on the Asian miracle in 1993, the World Bank even gave the eight “high-performing East Asian economies” a pass on their industrial policies. To be sure, governments had intervened to promote particular sectors. But they did so in “market-conforming” ways that did not fundamentally challenge neoclassical orthodoxy or the logic of comparative advantage.

What went wrong? What lessons can we draw? And could it happen again?

The Crisis Hits

The Asian financial crisis unfolded in several overlapping phases, beginning in Thailand and spreading first to other Southeast Asian countries. On July 2, 1997, the Thai central bank was constrained to let the baht float. The Philippines followed suit within a week, although it was ultimately less seriously affected. Indonesia signed a massive International Monetary Fund program in November, with the unfortunate optic of IMF managing director Michael Camdessus looking on with arms crossed as Suharto put pen to the agreement. Malaysia was also forced to give up its currency peg but in contrast to other countries refused to go to the IMF and a year later imposed controversial capital controls.

The second phase began with Taiwan’s decision to float its currency in October 1997. Speculation immediately shifted to the Hong Kong dollar, generating a sell-off in equity markets that spread worldwide. The crisis had gone global. South Korea marked the next stage. A number of large groups had failed earlier in the year, but in the wake of events in Hong Kong the country suffered a severe liquidity crisis and in November was forced to abandon attempts to prop up the won. Although somewhat less directly connected, the Russian crisis of the fall of 1998 could be considered an aftershock, since the economy was affected by the fall in demand and prices of commodities that accompanied the collapse of growth in emerging Asia.

One crucial background condition is often forgotten in the focus given to the developing economies of the region: the role of Japan. Japan should not simply be seen as one precipitating cause of the crisis, but an integral component. Japan witnessed a string of bank failures in late 1997, a tightening of monetary policy, and a sharp pullback in foreign lending that had immediate effect in the region. However, these developments were only the culmination of the slow bursting of the property bubble since 1990 and the inability — or unwillingness — to confront the deteriorating balance sheets of the major commercial banks. The lessons for China are significant and I return to them by way of conclusion.

The Debate Over Causes

All agree that a commitment to fixed exchange rates increased vulnerability to the financial crisis. Beyond that, diagnoses differed profoundly. Two broad camps staked out positions, each with widely — even wildly — divergent policy implications. In a subtle reversal of tune, many who had seen the East Asian countries as models to be emulated turned on them with alacrity. These new fundamentalists focused on the adverse effects of industrial policy and the moral hazard that undergirded it. Fiscal deficits looked small, but only if ignoring the contingent liabilities on bank balance sheets. Malaysia, South Korea, and Thailand all experienced bank-financed investment booms before the crisis, during which lending grew rapidly despite declining returns.

The policy implications? Not only did the banking sector need to be cleaned up, but governments had to reverse commitments to industrial policy and go after the crony capitalism that undergirded it. IMF programs were by no means limited to draconian — and controversial — fiscal and monetary policies but also to an array of structural reforms as well. In the Indonesian program, these ran into dozens of discrete measures.

The other camp encompassed an eclectic group that viewed the crisis in terms of self-fulfilling speculative attacks and contagion. The triggers of financial crises might be nearly random, yet once investors are spooked, they can respond not to fundamentals but to the action of other creditors. In a clever oxymoron, Radelet and Sachs referred to this process as “rational panic.”

A very different set of policy prescriptions followed. First, it was not state intervention that had driven the crisis but the failure to adequately regulate financial markets as they were liberalized. Political economy mattered as well, but in a very different way. Lax regulation and premature liberalization rather than state intervention were the primary culprits. Second, the solution to the crisis lay above all in provision of ample liquidity, a prescription that was blocked by the limited resources of the international financial institutions and the unwillingness of creditor countries to rapidly expand them.

These debates still resonate. The crisis led to a rethinking of prior industrial policies, to be sure. But the idea that financial internationalization carries risks has become an important lesson of the crisis as well, with particular emphasis on the importance of robust regulation.

Resolution: The Economic and Political Aftermath

Despite the rapid return to growth, it is hard to overestimate the human wreckage and generational impacts. Across the region, literature and film captured the debilitating psychological effects of the crisis. Recent migrants to the city in Bangkok and Jakarta returned to the countryside. Korean salarymen, with expectations of secure employment, were thrown into the informal sector. And amidst the downward mobility, luck — or connections — allowed some to escape the worst of the crisis, helping spark the resentments that increasing inequality generated.

But did the crisis have any enduring effects?

One immediate effect of the crisis was to reveal the inadequacies of the Asian social safety net. Out of necessity, countries shifted from a growth-at-all-costs approach to a reconsideration of their social policies. The region had generally done well in investing in education. Rapid growth allowed households to self-insure. But short-run safety nets and social insurance were weaker. Across the four most seriously affected countries, the poor — and especially the urban working poor — were the most vulnerable. Particularly in Indonesia, the large size of the informal and self-employed sectors posed daunting administrative challenges for effective anti-poverty measures. However, the crisis also hit the urban strivers with reasonably good jobs or thriving small businesses, but with relatively limited education or accumulated assets. The ability to move toward a comprehensive social insurance system was a function of the level of development in the first instance. But in the wake of the crisis, democracy played an important role in pushing along important innovations, from the gradual move toward universal health care in South Korea to a variety of pro-poor interventions in Indonesia in Thailand.

The debate on the social consequences of globalization has persisted but morphed. For the more advanced industrial states in the region — Japan, South Korea, and Taiwan — the forces that are generating rising inequality and other social stresses are quite similar to those in the other advanced industrial states. Globalization, technology, and the shift of employment into services all play a role. Taiwan, which with the Philippines managed to largely escape the 1997-98 crisis, shows the dynamic most clearly. Increasing integration with the mainland has benefitted capital, as cross-strait investment has exploded. The less-educated and skilled, by contrast, face greater exposure to imports from China and diminishing life chances.

A second outcome of the crisis was not only a reconsideration of industrial policy, but a new spotlight on the weakness of corporate governance. In the first instance, governments were forced to focus on the complex process of financial and corporate resolution and restructuring, a policy effort that took massive resources. Governments undertook the interconnected tasks of lending support to insolvent banks, recapitalizing them, disposing of non-performing loans, and restructuring corporate debt.

Yet longer-term reforms of corporate governance were equally important, and in some cases remain far from complete even to this day. Surprises persist in how far countries have come since the crisis in this regard. A well-known biannual survey of corporate governance by the Asian Corporate Governance Association ranks 11 Asian countries, including all of those affected by the crisis. Singapore, Hong Kong, and Japan lead the pack and Taiwan has recently moved up the rankings. But South Korea comes in at eighth — behind India and just ahead of China — and the Philippines and Indonesia rank 10th and 11th, respectively. And even in countries such as Malaysia that have made improvements in corporate governance in recent years, cronyism persists. The 1MDB scandal could have been ripped from the pages of a number of entities that failed — or were propped up — in the wake of the Asian financial crisis. Even if systemic risk has fallen, problems associated with large, family-controlled, and politically connected firms persist (as they do, it should be added, in the United States).

Finally, a word should be said about the political consequences of the crisis, and the performance of democratic and authoritarian regimes in particular. It is probably not coincidental that among the four most severely affected countries, the one that was most authoritarian (Indonesia) experienced the deepest economic crisis and also underwent the most profound political change. Once Suharto’s grip on power appeared shaky, challenges to the regime mounted and his authority swiftly deflated. To its credit — and to some outside surprise — Indonesia’s transition to democratic rule has proved more durable than those in Thailand and the Philippines. Meanwhile, Malaysia’s dominant party system, with at least some institutions of accountability, managed to hold on to power even if the crisis generated a new strand of opposition that that has persisted to this day.

What is noteworthy is that the democracies did not do badly, and in fact managed some serious reforms. Those enamored of the performance of the Asian authoritarian regimes overlook some interesting lessons of the crisis. Democracy might have delayed the adjustment process in South Korea and Thailand, but the democracies had an important self-correcting mechanism that the authoritarian regimes lacked. The system of government enjoyed support even if the incumbent politicians did not, and elections brought new reformist governments to office. Kim Dae-jung was particularly interesting in this regard, as he combined a center-left profile with commitment to reforms that sought to break up cozy state-business relations. Reforms in Thailand were more modest, but not insubstantial. Although these governments did not fully succeed, it is hard to argue that the democracies underperformed the more authoritarian regimes. Two cheers for democracy at least!

The International Setting

It is worth making brief mention of one regional consequence of the crisis: the emergence of institutions — however incipient — of regional financial cooperation. To be sure, the main reason why crises have not recurred and the region weathered the global financial crisis were actions that countries took on their own: abandoning fixed exchange rates (while nonetheless managing them), continuing pursuit of relatively cautious fiscal policies, and significant reserve accumulation. The system of export-oriented growth continued; some even talked about a new Bretton Woods system in Asia in the wake of the crisis, with managed exchange rates supporting a resumption of export-led growth targeting the United States. Nonetheless, the Chiang Mai initiative reflected a willingness of the surplus countries in the region to negotiate a limited set of swap arrangements within the region. At the time, this foray into financial cooperation was a first, and went well beyond what the ASEAN institutions had achieved up until that point.

Why the Asian Financial Crisis Still Matters: Is China Next?

The biggest question of all is whether the region remains vulnerable to such crises today. The great slowdown in Japan and the sharper contraction elsewhere in Asia in the late 1990s revealed what a number of economists had predicted: that very high growth was unlikely to persist, if only because of the law of mean reversion. The question was not whether the high-growth economies would slow down, but whether they would have hard or soft landings. Not surprisingly, the same debate is being replayed now with respect to China. And as prior to most crises, complacency is high. Too many voices are saying “China is different,” the exact mantra that has proven a leading indicator of virtually all financial crises.

Despite its socialist differences, China shares many features of with the other Asian miracles, indeed even in exaggerated form. Fundamental reforms and exports have played a role in the country’s extraordinary growth trajectory to be sure, but investment has been a major driver. As the economy has slowed, productivity is not adequate to sustain target growth rates. Virtually the only instrument available is to maintain investment through lending that is ultimately government-backed. And politically-connected firms abound. Sound familiar? Not only is debt piling up, but as in the period prior to the Asian financial crisis there is uncertainty about the balance sheets of banks, corporations, and other entities that operate in the shadow banking world. As in the American financial markets prior to the global financial crisis, assets that are deemed off the balance sheets of banks — and governments — are almost certainly going to be on them when the inevitable reckoning comes.

So what is similar and what is different? In the first instance, China’s debt-led growth has not been financed from abroad and the country has accumulated substantial reserves, a pattern followed by other countries in the region in the wake of the crisis as we have seen. Second, the government also probably has the tools to control capital outflows, which could otherwise generate the vicious cycle of depreciation, deterioration of bank balance sheets, more depreciation. The highly directive nature of the country’s political economy also has advantages as well as disadvantages. There is little doubt that the regime would act with alacrity in managing the liquidity crises that are almost bound to emerge and has ample tools to do so.

But those observations are limited comfort, and it is the Japanese rather than developing country parallels that may prove the most significant. There are few forecasting that China would suffer the slowed growth Japan experienced in the 1990s if the Chinese bubble were to burst. But like Japan, what happens in China has effects not only in the region but well beyond it.  And there is the additional question of how the Chinese political order would respond to a fundamental rupture in the social contract, even if short-lived. Perhaps the most important lesson of the crisis 20 years on — as with the global financial crisis that erupted a decade later — is to remind ourselves that “it can happen here.”