The Asian Financial Crisis: A Ten-Year Retrospective on the Winds of Fortune

Gone with the Wind: Theories on the Blowup

A financial typhoon appeared in the Gulf of Siam on July 2, 1997. It first toppled the Baht and the Thai economy and then swept to-and-fro across East Asia for the next eight months, doing severe economic and political damage to South Korea, Indonesia and Malaysia. The ripples of the typhoon were felt as far as Brazil and Russia, producing an equally disastrous outcome in the latter. Post-mortems have abounded since, with each autopsy report giving a different combination of the following three themes:

Theme 1: The victim died because she was already so wasted internally by self-inflicted wounds that she keeled over when the wind started blowing. The role of the storm was happenstance because a much softer breeze would also have done it later when her constitution had become more frail.

Translation: Prior to July 2, 1997, crony capitalism and economic mismanagement in the affected Asian economies had loaded their national financial systems with weak loans, and hence rendered continued high growth unsustainable. These Asian economies imploded for the same reasons the Soviet bloc economies imploded in the early 1990s.

Theme 2: The victim died because she was crushed in her sleep by the coconut tree brought down by the gale.

Translation: International financial markets, just like domestic financial markets, are susceptible to bouts of mania, panics and crashes, causing them to help stoke booms and busts in their clients' performance (which in the periods of irrational exuberance are often bestowed congratulatory honors like "The Asian Miracle," and "Japan as No. 1").

Theme 3: The victim died not from the bad cold she caught with the change in weather but from the mistaken administration of nitrogen instead of oxygen while in the ambulance on the way to the hospital.

Translation: The incompetence of the IMF turned a downturn into a depression with overly contractionary macroeconomic policies, and helped to exacerbate (if not initiate) the regional panic with dire diagnoses of the patient. The Koreans were correct to dub the perfect storm they found themselves in "The IMF Crisis."

It is convenient to give the greatest emphasis to Theme 1 because no economy is without flaws. However, the observation that output in Malaysia, South Korea and Thailand rebounded just as quickly as it had fallen lends support to Theme 2; output plummeted when the international financial markets panicked, and output recovered once the panic had run its course. Certainly, fragile domestic financial systems deepened the output dive but they just would not have imploded on their own at the same time in all countries -- an outcome akin to all their warranties expiring on the same day.

Looking forward, what are the fundamental lessons from the crisis then and how should we translate them into policies?

The Answer is Blowing in the Wind: The Reality of the Crisis

Of the many important insights identified in the voluminous literature on the crisis, there are two that are particularly important to consider given their broad implications for economic management and sustained development. The first insight concerns the natural working of the market mechanism, and the second deals with the broader context within which the market mechanism operates.

First, the Asian financial crisis reminds us that financial markets malfunction once in a while (possibly, a long while) because of excessive speculation followed by over-correction of asset prices.

There has long been a tradition of resistance within the economics profession to acknowledge the phenomenon of disorderly market behavior. The most commonly used defense against claims of speculative bubbles is the alternative hypothesis that unstable asset prices reflect unstable government policies. The claim (labeled the "peso problem") is that observed flip-flop movements in asset prices reflected rational anticipations of changes in government policies that turned out not to occur. The truth is that the peso problem hypothesis cannot really be disproved because there is just no way of getting around the sophistry of a determined peso problem believer.

The fact that financial contagion has been common in the 1990's can be proven by examining recent history: the European Exchange Rate Mechanism crisis in 1992-93, the Mexican and Latin American financial crisis in 1994-95, the Asian financial crisis in 1997-98, the conversion of the Russian ruble to a rubble in August 1998, and the collapse of the Brazilian real in January 1999. It stretches credibility and the imagination that all these governments coincidentally shifted to destabilizing policies in the same decade.

The unpleasant truth is that "bad things can happen to good people" and economic disasters are not necessarily penitence for economic sins. The rejection of the dogmatism of the peso problem approach leads naturally to the rejection of the dogmatism of unreflective market bias. The use of temporary capital controls in Malaysia during the crisis is instructive. The faintest praise for the Malaysian capital controls is that they did not render the recovery in Malaysia to be slower than in the other crisis countries. More fulsome praise would point out that the 1998 collapse in Malaysia was smaller than in Thailand and the Philippines, and that the 1999 recovery in Malaysia was faster than in these two countries. The main cost of the controls was that Malaysia missed most of the international capital that returned to the region at the end of 1998. The temporary controls do not appear to have engendered any long-run negative impact because the risk premium today on Malaysian-issued Eurobonds is not higher than those charged of its neighbors.

The second critical insight from the Asian financial crisis is that "getting the institutions right" is just as important as "getting the prices right."

This conclusion is suggested by the case of Indonesia, which experienced a larger output loss and a slower recovery compared with its neighbors. The Indonesian outcomes came from a flawed political system rather than from a flawed economic system. In the three-decade long rule of Suharto, he relied upon satisfactory economic growth as the justification for his stewardship of the country. Instead of establishing political institutions to resolve issues about regime legitimacy, political succession, administrative transparency, regional concerns, ethnic disputes and religious tensions, Suharto resorted to political manipulation, co-optation, and occasional violence to minimize discussions of these issues. The result is that beneath the façade of stable rule buttressed by support from the armed forces, social dissatisfaction with the Suharto regime was rising in step with the expansion of the middle and professional classes, and in step with the growth of special economic privileges to Suharto's children (who received increasing numbers of subsidised bank loans and monopoly import licenses).

Once the Asian financial crisis revealed that the aging Suharto had become an incompetent manager, there was massive withdrawal of political support by the upper and middle classes, and factionalism within the army and the civilian bureaucracy spun out of control. The Indonesians, unlike the Malaysians, the South Koreans and the Thais, did not have the option of expressing their outrage at gross incompetence through the ballot box, and so they expressed their outrage in the only form available to them -- a social explosion that deepened and prolonged the economic meltdown. The Indonesian experience is consistent with the hypothesis that socio-political development must accompany economic development in order to maintain the social stability required for steady high growth. The case for the expansion of democratic political institutions is thus based not only on moral ground but also on pragmatic, long-term economic considerations.

Of course, political institutions are only a subset of the institutions that have to be in place in order to promote economic growth. The efficient working of the market mechanism necessitates the presence of infrastructural institutions like modern corporate governance; well-defined, transparent bankruptcy procedures; protection of intellectual property rights; and prudential supervision of the financial sector. Furthermore, only if an efficient, objective legal system is already firmly in place, can democratic political institutions and the infrastructural institutions of the market work to their full potential.

Catching the Second Wind: Recommendations to Avoid Another Crisis

Looking ahead with these lessons in mind, what work remains to be done to continue strengthening developing economies to reduce future vulnerabilities?

First, the financial markets in most developing countries still require substantial reform: prudential regulation and supervision must be strengthened, accounting practices be brought up to international standards, balance sheets be reported more fully and more frequently, and regulations for the entry of foreign banks be relaxed more.

Second, external supervision of the IMF must be increased and improved further, and this requires that the IMF's decision-making process become much more transparent and include the input of a larger number of developing countries. The poor performance of the IMF in the Asian financial crisis, and the Russian and Brazilian crises were not isolated events, as attested by the spectacular flame out of the Argentinean economy in January 2002, and should not be treated as such.

Third, the IMF cannot, and should not, be either the international lender of last resort or the international deposit insurance agency. In such circumstances, generalized floating of exchange rates should be the norm for the international monetary system. The new monetary system should establish regional monetary bodies, and an international bankruptcy court to speed up international debt restructuring. The standard features of domestic bankruptcy procedures should now be part of international rescue packages.

Fourth, the regulation and monitoring of international capital markets should be stricter and internationally coordinated. The chief regulatory reforms are prudential restrictions on short-term capital inflows, and the further liberalization of long-term foreign direct investments. In order to bridge the differences between the developed and developing countries, the United Nations should take the lead in convening a meeting of international organizations on this important question.

Finally, Asian countries must now tackle challenges within their social infrastructure and political institutions in order to strengthen long-term economic prospects. There is a serious mismatch in Pacific Asia, particularly in most of Southeast Asia, between investment in physical hardware (factories and machinery) and investment in the social software (scientific research centers, administrative and judiciary systems, and growth of civil society). While it is now increasingly recognized that the enrichment of the domestic scientific base is crucial for sustaining high economic growth, it is less recognized that Asia's flawed social infrastructure and inadequate political institutions -- which have allowed for too much corruption and mismanagement -- are a cause for serious concern. In a world of growing international competitiveness, when foreign direct investors are courted not just by Asia but Central Europe and Latin America, the concerns over governance are bound to grow, and to weigh increasingly heavily on the inadequately reformed countries of Asia.

In short, the long-term growth of Asia rests both on Asia getting its institutions right and on the international community getting the global institutions right.