East Asian Financial Crisis - Essay Example

Literature Review The East Asian crisis could be considered as one of the most important of all financial events in the twentieth century, to have hampered the smooth functioning of various economies throughout the world. Though the causes of the crisis, as figured out by eminent observers, did not correspond much with any such crises in the past, its impact had far-fetched effect. Economists consider it to be almost a lesson and had tried to evaluate the actual causes that led to it. In addition, it is also important to know the outcome that the factors followed. Hence, overall, the subject of East Asian crisis is till date, a highly discussed topic among economists. The following sub sections provide a review of past researches made on the area and try to encompass the causes as well as the impact of the East Asian financial crisis of 1997-98. In addition, a paragraph has been added as a conclusive note about the lessons learnt from the crisis, as figured out by various researchers. Origin of the East Asian Financial Crisis of 1997-98 The East Asian financial crisis of 1997-98 culminated into one of the most devastating global shocks in the twentieth century. Its far-fetched effect could be compared with nothing less than that of the Great Depression of 1930s which had entwined the US economy into stagflation. In fact, what prevented the 1930s depression from spreading out throughout the world was the lack of ample networking among various economies. On the other hand, the impact of the East Asian crisis by the end of the millennium was more brutal or burgeoned due to a close-knitted financial relationship already been accomplished between them. The link was especially prominent among the underlying economies in South East Asia, bound together by a regional pact ASEAN that aimed at strengthening and shielding at the same time, the international trade position of the East Asian tigers. These economies had secured massive as well as exemplary economic growth rates that awed many others. When these economies were recording a growth in real income equal to 7 percent per annum, the US economy lagged behind at a modest 2 percent (Mankiw, 2003). Many nations tried to imitate the fiscal configuration of policies being framed by these nations. However, the cheap labor that the economies in the South East Asian region were endowed with, could not be equaled anywhere else in the world. Hence, it was infeasible for others to carry on their production and supply their outputs at competent prices in the world market. In contrast, the East Asian tigers managed to provide quality goods at relatively inexpensive rates, unlike the developed nations, especially the US. So, the key reason that led the East Asian tigers towards the path of unabashed glory was the strategy of export-led growth and an environment free of trade barriers. Corruptions in the Political Sphere as the advocating source of the crisis Even amidst this economic glorification, the nations could not help subsiding into a terrible financial crisis which had far-fetched implications on their economies. The crisis originated in the banking sector of the region, which had incorporated ruthlessness in their business activities to some extent. It is often claimed that there was a twinge of politics involved behind the ballooning impact of the crisis or rather the initiation of the crisis at the first place. In fact, at a time that witnessed perhaps the highest number of nations inculcating a transition phase, such crises were common. This might be verified from the fact that the East Asian crisis surfaced at a time when Latin America was recuperating from a financial distress (Mankiw, 2003). Nevertheless, the role played by the political influences in the regional financial sector cannot be denied in the latter case. It was later figured out that the domestic banking sectors favored the ones with high political contacts rather than those who had a greater credit-worthiness of repaying debts. This was realized to be one of the key factors since the regional crisis had no symptom in common with any of the financial crises that the world had seen. Apart from corrupt banking practices, lack of transparency in corporate governance and a mismanaged administration are also to be blamed for the crisis that hit the fastest growing region in the world with such devastating effects (Radelet & Sachs, 1998). The corporate houses that usually had high political connections, secured huge amounts of financial debts from the banking sector rather than relying more on investments made b shareholders. The advantage of debt financing was that, it levered the risk of the entrepreneurs. Though such a move enhanced the assets of the commercial banks, they faced the risk of loan defaults (Lau & Li, 2000). The banks targeted advancement of loans to the people with high political connections or their own kinsmen, irrespective of their credit worthiness – a situation commonly known as ‘crony capitalism’. This culminated into weak returns from investment and a huge concentration of bad debts within the system. The foreign investors did not take much time to realize that investments made in the East Asian economies could not yield their expected returns since the nation was losing its investment potentials at a rapid pace. This preceded the explosion of the asset bubbles in the banking sectors of the region, which led to a massive capital flight (Frank, 2006). Thus, the origin of the crisis imparts how unripe policy structure and a lack of effective instruments for implementation might prove fatal for economic growth. The Contagion Effect Though, political influence had a vigorous impact on the regional banking structure, it was the contagion effect that existed among the nations which was responsible for the widespread impact. Contagion effect is that which encompasses a handful of nations integrated together by some economic or political pact, such that any shock arising in one of them is reflected in its allies. The ASEAN bounded these nations together and made the external economies to believe that a monetary move in one of them will send ripples in its associates too. In fact, the East Asian nations had involved themselves in a similar trade-centric growth strategy, where the nations used to export large quantities of electronic goods characterized by high quality but cheaply priced. This joint effort to invigorate the regional economic growth strengthened the terms of the pact more than the official pact itself, among the overseas entrepreneurs (Rude, 1998). Capital account convertibility that triggered the crisis After the region had splurged itself into a callous lending spree, without an examination into the credit-worthiness of the borrowers, the outcome was evident. The banking sectors of the economies were faced with a huge pile of bad debts and soon were driven out of all their resources. These resources accumulated over the years through following an export-led economic growth strategy, were soon squandered and the region was left in a situation close to that of destitution (Radelet & Sachs, 1998). However, another important aspect that could be held equally responsible for the crisis is that of allowing a full capital account convertibility situation. Capital account convertibility allowed the foreign investors to invest in assets domestic to the South East Asian region without any financial obstructions occurring on account of imposition of stringent exchange rate regulations. The overseas investors were soon attracted towards venturing their resources in the South East Asian region with a motive to earn high rates of return. Firstly, the region had relaxed almost all the factors that could bar the inflow of foreign direct investment and secondly, the region reported the highest economic growth within a very short span of time which made it appear as a highly viable investment ground (Zhuang & Dowling, 2002). This could be described as nothing less than ‘herd-behavior’ where the overseas investors made their investment decisions following those of their peers. This led to a situation commonly described as “too much money chasing too few goods” and hence, ballooning of asset price bubbles (Lau & Li, 2000). With an effort to revive the situation, Thailand made the first attempt of devaluing its domestic currency against that of the US economy. This seemed to be the only solution to stabilize the dwindling financial situation at that time. But, the contagion effect that had encircled the region did not spare other economies from external predictions of a downfall. Speculators predicted that the region was soon to lose its global hold and what happened to be a financial haven once witnessed large-scale capital flight. Since Thailand had already devalued the Baht and introduced a floating exchange rate regime meanwhile, the nation was relatively shielded from the intensity of the crisis. However, Indonesia happened to be the most hardly hit among all its neighbors, with the domestic stock exchange reporting a 90 percent fall in value and its domestic currency, Rupiah, devaluing by 80 percent against US dollar overnight. A fall in stock prices is balanced through a rise in the market rate of interest. Indonesia recorded a 50 percent hike in its rate of interest over the same period (Mankiw, 2003). However, a rise in the rate of interest is also associated with a fall in the rates of investment made by the entrepreneurs especially the ones based overseas. Withdrawing of investment funds from one economy, namely, Indonesia compelled the speculators to believe that the region is at the verge of a downfall or rather a financial collapse. Hence, they started withdrawing their funds from the domestic stock markets in all the underlying economies, so that the entire region experienced a stock market crash. Malaysia and South Korea were the next victims of such speculative attacks, which drove them out of all resources to be invested in their economy or to prop up their respective domestic currencies. So, there was widespread currency devaluation in the East Asian region during 1997-98. Impact of the East Asian Financial Crisis of 1997-98 The East Asian financial crisis of 1997-98 emerged in the banking sector of the region and entangled the entire economy in a glitch. The crisis had far-flung implications on the future of the region as has been pointed out by various economists and researchers. The first and foremost impact of the shock was a massive capital flight from the region that resulted to stock market crash throughout. However, the effect did not remain restricted within the boundaries of the East Asian region, but rather was reflected in other significant corners of the world. When the overseas investors withdrew their money from the South East Asian market, they had to kill their prospects of earning high amounts of returns from them. Hence, many enterprises in the West that laid down their expectation on these yield, had to surrender to the crisis. The plights of the developing nations were beyond description, since the Western economies now feared to believe in the economic principles of the emerging market nations and thus terminated their financial support in the form of investments (World Bank, 1998). Much of the global economic growth at that time accounted for the high growth rate of the East Asian region. At a time when the US recorded a modest 2 percent economic growth rate, the same was equal to almost 7 percent with all the East Asian economies combined. Quite obviously, a capital flight resulted to a considerable drop in the investment ventures being made in the region and thus a fall in its growth rate. The economic growth rate in the region slashed down by 0.5 percent by the end of 1998 (World Bank, 1998). A fall in the economic growth rate played the role of a vicious cycle that indicated a further deference by the investors. The lower that the growth rate was recorded, lower was the inflow of foreign direct investment in the region which resulted to a lack of resources to prop up the domestic currencies. Moreover the region lurked in the problem of credit crunch due to crony capitalism which too was an immature one to some extent. Lack of efficiency in corporate governance deterred most of the foreign banks to forward loans to their East Asian counterparts, so that the latter could not procure the amounts necessary for triggering investment initiatives. Hence, the region experienced exchange rate devaluation. In addition, there was a rise in the rate of unemployment being experienced by the region. A high economic growth rate created a high demand for labor in the domestic factor markets. For instance, South Korea recorded an average marginal rate of unemployment at 2.2 percent between 1989 and 1997. However, an abrupt fall in the economic growth rate corresponded by a fall in the demand for labor, led to a rise in the unemployment rate in the economy by 6.2 percent in the first quarter of 1999. A similar story was found in cases of South Korea and Malaysia, while in case of Indonesia, the brunt in the labor market was mitigated due to a large part of its total labor force employed overseas. However, the workers who had migrated to the neighboring economies of Indonesia and South Korea returned back to their native land due to job contractions taking place in the latter (Mahmod & Aryah, 2001; Islam, et al., 2001). Theory of Phillips curve proposes that inflation rate and unemployment rate are inversely related with each other, i.e., there is always an inherent trade-off between the two economic vices. When the rate of unemployment rises in an economy, it implies a fall in the rate of production in the nation. On the other hand, a fall in the demand for labor leads to a fall in the equilibrium nominal wage rate and thus, a decline in the per capita income. This naturally leads to a downward pull in aggregate economic demand and thus, a fall in the retail prices of the final goods sold in the market, leading to deflation or recession (Mankiw & Taylor, 2006). A similar situation was reflected in the South East Asian region of the world, where a fall in the rate of employment led to a fall in the aggregate demand for commodities and thus, recession. In addition, due to a subtraction in the channels of resources inflows, all the previous economic problems which the region had successfully fought over started riding back. For instance, the governments of the underlying nations had successfully curbed poverty, improved health care and enhanced education quality in the region since the last few years, through adoption of many effective policies as well as through forwarding financial aids to the respective sectors. However, a financial distress forced them to withdraw all these supports so that the problems started recouping once again (United Nations, 1999). However, the problem of recession was temporary in nature, and was correctable through devaluing the rate of exchange maintained by these economies with the US dollar. But, it was soon realized to be an inflationary move and submerged the region into high inflation. The situation in Indonesia was comparable to the hyperinflation being experienced in Mexico, just before the East Asian crisis sunk in. The annual rate of inflation in the economy was recorded at 57.6 percent in 1998, in contrast to 8.8 percent between 1990 and 1996. Inflation rates for the neighboring economies of South Korea and Malaysia, though had increased, were far lower than the former. To alleviate the impact of inflation, the corporate houses in the economies initiated a slash-down in the nominal wage rates so that the real wage rate in the region eroded at an exceedingly high pace (Horton & Mazumdar, 2001). But this deflation seemed to be a blessing in disguise for these nations which employed this feature to produce relatively cheaper goods and sold them at international markets with a greater vigor. So, the nations which had allowed depreciation in their rate of exchange were at a stage of recuperating from the crisis, though, there were some like Hong Kong which had been particularly stringent about its exchange rate regimen and thus, suffered. In fact, this sufferance was more relative in nature since, the only tool that could revive these economies from the crisis was an intensified export policy. But with all the surrounding economies, endowed with equally efficient factors of production, having promoted currency devaluation mitigated the prospects of Hong Kong gaining from such a move (Yao, 2001). Lessons learnt from the crisis The East Asian financial crisis could be compared with nothing less than an eye-opener, where the efficiency of the operations of international financial organizations in the likes of the IMF or the World Bank, appeared to be at a crisis. It was accused that the organizations lacked proper monitoring instruments that could keep a close vigilance on the activities of the South Eastern banking sector. It is often claimed that a more careful attention could have saved these nations from the credit crunch problem that hovered the region following the speculative attacks (Zhuang & Dowling, 2002). In addition, the nations also lacked a democratic system, which could have prevented corrupt practices to some extent (Yung-Myung, 2003). References Frank, (2006). Principles of Economics. New York, USA: McGraw-Hill. Horton, & Mazumdar, (2001) ‘Vulnerable groups and the labour market: The aftermath of the Asian financial crisis’ in Betcherman, G. & Islam, R. (eds), East Asian Labour Markets and the Economic Crisis: Impacts, Responses and Lessons. Washington, D. C., USA: World Bank Publications. R. Islam and others, 2001, “The economic crisis: labor market challenges and policies in Indonesia” in G. Betcherman and R. Islam, eds., East Asian Labor Markets and the Economic Crisis: Impacts, Responses and Lessons, World Bank and International Labour Organization (Washington, DC and Geneva) Lau, L. J. & Li, K. (October, 2000). ‘The East Asian Currency Crisis and Recovery’. Available at http://www.stanford.edu/~ljlau/Presentations/Presentations/102700.PDF (Accessed: March 9, 2010). M. Mahmod and G. Aryah (2001), ‘The labor market and labor policy in a macroeconomic Context: Growth, crisis, and competitiveness in Thailand’ in Betcherman, G.& Islam, R. (eds.), East Asian Labor Markets and the Economic Crisis: Impacts, Responses and Lessons. Washington, D.C., USA: World Bank and International Labour Organization. Mankiw, N. G. (2003). Macroeconomics (5th Edition). USA: Worth Publishers. Radelet, S. & Sachs. J. (March, 1998) ‘The Onset of the East Asian Financial Crisis’. Available at http://www.earthinstitute.columbia.edu/sitefiles/file/about/director/pubs/paper27.pdf (Accessed: March 9, 2010). Rude, C. (July, 1998) ‘The 1997-98 East Asian financial crisis: A New York market-informed view’. The World Bank (March, 1998), ‘What effect will East Asia’s crisis have on developing countries?’, PREMNotes Economic Policy, Number 1. Available at http://www1.worldbank.org/prem/premnotes/premnote1.pdf (Accessed: March 9, 2010). Zhuang, J. & Dowling, J. M. (October, 2002) ‘Causes of the 1997 Asian Financial Crisis: What Can an Early Warning System Model Tell Us?’, ERD Working Paper Series No. 26, Asian Development Bank. Available at http://www.adb.org/Documents/ERD/Working_Papers/wp026.pdf (Accessed: March 9, 2010). United Nations (1999) “Social impact of the economic crisis” in Economic and Social Survey of Asia and the Pacific 1999, United Nations publication. Yao, Y. C. (2001) The Asian financial crisis and the ordeal of Hong Kong. USA: Greenwood Publishing. Yung-Myung, K. (2003) ‘Understanding East Asian Political Systems: Origins, Characteristics, and Changes’, Sungkyun Journal of East Asian Studies, Vol. 3, No. 1, pp. 45-78. Sungkyunkwan University, The Academy of East Asian Studies. Read More