Between 1990 and 1996, capital inflows to emerging market countries rose from $60 billion to $194 billion. No one carefully monitored these capital flows. When problems developed in Asia in 1997, neither the IMF nor the private lenders knew the true magnitude of the debts of some of these countries. Firms borrowed directly and through their subsidiaries. Often, the total was not shown on any balance sheet. The provision of the IMF Articles of Agreement requiring surveillance and the decision to strengthen surveillance following the 1995 Mexican crisis proved to be of little use. Though important, the IMF's failure to monitor seems small beside the elementary mistakes of private lenders. The lenders ignored three principles of prudent behavior that history has shown repeatedly to be a major reason for financial failure.
First, Asian banks and other Asian borrowers used short-term renewable credits from foreign banks to finance long-term loans (maturity mismatch). All banks do this to some extent, but the extent matters a great deal. When foreign loans were not renewed, the Asian banks and corporations faced large defaults. Second, Asian banks and corporations borrowed in foreign currencies and loaned in local currency (currency mismatch). They accepted the exchange risk without hedging. They failed to realize that the difference in interest rates included the risk of currency depreciation. Third, many international bankers did not ask to see consolidated balance sheets. They did not monitor the total assets and liabilities of the borrowers.
The IMF and the principal governments lent a total of $119 billion to Indonesia, Korea, and Thailand so that they could pay the interest on the existing bank loans or repay the principal. Extending new credit helped the Asian banks to avoid default, but money went to the foreign banks. International bank loans were in dollars, yen, and other hard currencies. Instead of taking large losses like the holders of currency, stocks, and bonds, the international banks collected their loans with relatively small losses. And in exchange for extending repayment, the banks collected fees for renegotiating the loans. They demanded government guarantees of the loans they made to banks, financial institutions, and private companies. Allen Metzer believes that this policy is the fourth mistake, because it may invite a larger financial crisis in the future.
Source: Allen H. Metzer, "Asian Problems and the IMF," The CatoJournal, Winter 1998, pp. 267-8.
Asian economic growth and hurt corporate profits. These slow economic growth and low corporate profits turned ill-conceived and overleveraged investments in property developments and industrial complexes into financial disasters. The crisis was then touched off when local investors began to dump their own currencies for dollars and foreign lenders refused to renew their loans. It was aggravated by politicians in these affected countries, who preferred to blame foreigners for their problems rather than seek structural reforms of their economies. Both domestic and foreign investors, already nervous, lost yet more confidence in these nations and dumped more of their currencies and stocks, driving them to record lows.
The panic view Subscribers to the panic view admit that there were vulnerabilities: increasing current-account deficits, falling foreign-exchange reserves, fragile financial systems, highly leveraged corporations, and overvaluation of the real exchange rate. Still, these vulnerabilities were not enough to explain the abruptness and depth of the crisis. They argue that economic fundamentals in Asia were essentially sound.
Developing countries that had experienced financial crises in the past, such as the Mexican peso devaluation of 1994 and the Latin American debt crisis of the 1980s, typically shared a number of common macroeconomic imbalances. These imbalances included large budget deficits, large public debt, high inflation caused by a rapid growth in money supply, slow economic growth, low savings rates, and low investment rates. By contrast, most Asian economies engulfed by the crisis had enjoyed low budget deficits, low public debt, single-digit inflation rates, rapid economic growth, high savings rates, and high investment rates. In other words, the Asian crisis differed from previous developing country crises in which financial decisions in the public sector were the main sources of difficulties. Public borrowing played a limited role in the Asian crisis.
The absence of the macroeconomic imbalances typical of past crises led some to argue that the Asian crisis was not caused by problems with economic fundamentals. Rather, a swift change in expectations was the catalyst for the massive capital outflows that triggered the crisis. The panic view holds that problems in Thailand were turned into an Asian crisis because of international investors' irrational behavior, and because of overly harsh fiscal and monetary policies prescribed by the IMF once the crisis broke.
Several factors support the premise that the crisis was panic-induced. First, no warning signs were visible, such as an increase in interest rates on the region's debt, or downgradings of the region's debt by debt-rating agencies. Second, prior to the crisis, international banks made substantial loans to private firms and banks even though they did not have government guarantees or insurance. This fact alone contradicts the idea that moral hazard was so pervasive that investors knowingly made bad deals, assuming that they would be bailed out. It is consistent, however, with the notion that international investors panicked in unison and withdrew money from all investments — good or bad.
Third, once the crisis was under way, the affected countries experienced widespread credit crunches. For example, even viable domestic exporters with confirmed sales could not obtain credit, again suggesting irrationality on the part of lenders. Finally, the trigger for the crisis was not the deflation of asset values, as fundamentalists argue; instead, the sudden withdrawal of funds from the region triggered the crisis. Radelet and Sachs (1998) state that some of the conditions the IMF imposed on these crisis countries for financial assistance added to, rather than alleviated, the panic. A key feature of the financial crises since the 1980s has been the existence of contagion. The panic view is consistent with the concept of financial contagion, which occurs when: (1) events in one financial market trigger events in other markets; and (2) the magnitude of the response in the other markets appears unfounded in economic fundamentals. In all three crisis episodes discussed above, a crisis that began in one country quickly spread beyond its borders. In some cases, the next victims were neighbors and trade partners; in others, they were countries that shared similar policies or suffered common economic shocks. At times, as in the summer of 1998, changes in investor sentiment and increased aversion to risk contributed to contagion within and across regions.
Policy responses Just like the previous developing-country crises, lenders, borrowers, and international financial institutions worked together to overcome the crisis. External payments were stabilized through IMF-led aid programs, the rescheduling of short-term foreign debts, and reductions in foreign borrowings through painful reversals of current-account deficits. The IMF has established new financing packages to encourage the adoption of policies that could prevent crises in selected developing countries.
East Asian countries closed many ailing banks, cleaned up nonperforming loans, encouraged surviving banks to merge with other banks, and compelled these banks to meet the capital adequacy ratio set by the Bank for International Settlements. Corporate-sector reforms included capital structure improvement through debt reduction, business restructuring to remove excess capacity, the reorientation of conglomerates on core specialists, and the upgrading of corporate governance standards. These countries also implemented market-opening measures to facilitate foreign investment.
These and other policy responses strengthened financial systems, enhanced transparency of policies and economic data, restored economic competitiveness, and modernized the legal and regulatory environment for more stringent regulatory oversight and consistent application of accounting standards. A modest rebound in exports, stock market prices, and capital investment began to take place in 1999 as a result of these policy responses to the Asian crisis.
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