The Economic Debacle in Northeast Asia: Economic, Political and Social Legacies

Bates Gill, Alexander Huang, Masaharu Kohno, Guoqiang Long, Se-Il Park, Masabumi Suzuki, and Sergei Troush

Executive Summary

With the devaluation of the Thai baht in July 1997, the Asian economic and financial crisis spread across East Asia devastating much of the region’s economic success story. Two years later, the economic doldrums linger in Northeast Asia, in spite of an impressive comeback in some countries such as South Korea, and the relatively unaffected Taiwan. Japan’s unemployment rate reached 4.9 percent in June 1999, the highest level recorded since the statistic was initiated in 1953; unemployment in South Korea soared up from 2.1 percent in October 1997 to 8.7 percent by February 1999; China’s hulking state-owned industries are laying off tens of thousands in an effort to stay competitive. What little hope Russia’s Far East may have had of integrating more beneficially in the East Asian economic miracle is now on indefinite hold. Meanwhile, consumer confidence is way down in the region, with investors only cautiously returning.

Perhaps more importantly-but less-frequently considered-are the long-term political and social effects of the crisis. Social and political upheaval in Indonesia stands out as the most obvious example, but the crisis also affected the politics and social cohesion of others in the region: there have been protests and political shuffling in Malaysia, the opposition came to power in South Korea, political divisiveness appeared in Japan, and painful reform measures have been introduced in China. Even as the region recovers economically, these political and social effects may well have the greatest impact on the governments, economies and societies of the region.

In this report, the seven authors-all policy analysts or practitioners specializing on Northeast Asia-take a critical look at the economic, political and social legacies of the crisis, and offer reasoned policy prescriptions as their governments pursue varied paths to cope with its long-term aftershocks.

China: While not feeling the immediate effects of the crisis, China faces looming related problems as its export industries struggle to compete, foreign investment is down, and the country’s delicate banking sector comes under increasing pressure. Steady robust economic growth, public spending, introduction of re-employment services, and reliance on massive foreign reserves stand out as policies to protect China from the worst effects of the crisis.

Japan: The country remains mired in the worst economic recession of its postwar history. The recession has had a devastating effect on the Japanese psyche, and threatens to turn Japan even more inward and question the principles of globalization and free markets. Badly-needed reforms will be hindered by the paralyzing effects of the crisis itself, as well as the fractiousness which will dominate the Japanese political scene for the foreseeable future.

Korea: Regarded as an economic success story, the country experienced a tremendous setback as a result of the crisis. Politically divided, South Korean leaders have made important strides forward, but industrial restructuring remains sluggish and unemployment is high and may go higher. The Kim Dae-jung government must step up efforts in key areas: avoidance of the politicization of the reform process, dealing firmly with vested industrial interests, expanding public assistance programs, and sustaining a national consensus in favor of reform.

Russia: The Russian Far East, already economically lagging behind much of the rest of Russia, let alone East Asia, now faces an even dimmer economic future in the wake of the crisis. Hopes for renewed investments from Japan and Korea are premature. Looking ahead, the Russian Far East’s best hopes should be staked in political and economic integration with East Asia through the “permeability” of China and Chinese ports on the East China and South China Seas.

Taiwan: Economic indicators show Taiwan was able to avoid the worst of the financial storm. In addition, developments on the social and political front provide further evidence that people in Taiwan responded to the regional chaos in a unique and largely beneficial way. Having instituted fiscal, economic and political reforms over the past 10 to 15 years, and relying on large foreign currency reserves, Taiwan has been able to minimize the negative economic impact from the Asian financial crises and keep the best performance record in the region.



The crisis has affected China, though as yet not so directly. Three principal points summarize China’s situation in the wake of the Asian financial crisis. First, in terms of trade, because China’s main exports face a demand shortage at home, it is difficult to overcome shrinking overseas markets. Exports are crucial to China’s economic growth and employment; unfortunately, the crisis-affected region accounts for about 60 percent of China’s merchandise exports. With shrinking demand from the region, in the first half of 1998, China’s exports to Southeast Asia, Japan and Korea fell by 12.9 percent, 4.3 percent and 30.2 percent respectively.

Chinese exports face increasing competition from the region’s affected economies, especially owing to the appreciation of the Chinese renminbi (RMB) against other affected currencies; about 15 percent of China’s export goods overlap with exports from affected economies. Competitive pressure from currency-devalued economies has intensified, and may increase in the future. China’s monthly export growth rate has declined steadily, and went into negative growth in August 1998, with a record negative growth rate of 9.2 percent in October 1998.

Second, the crisis negatively affected China’s ability to attract foreign investment, a critical factor behind China’s economic growth. Foreign funded enterprises are the most dynamic part in the Chinese economy, accounting for approximately 50 percent of exports and employing some 18 million workers. Because about 80 percent of China’s foreign investment came from the crisis-hit region, many ongoing projects encountered financial difficulties. Both contracted and realized investment from the crisis-hit region fell by about 11 percent in the first ten months of 1998. Investment from Japan decreased by 25 percent in the first nine months of 1998-the fourth year in a row for declining Japanese investment in China. In addition, China may have less interest in export-oriented projects because of relative RMB appreciation.

Indirect international financing has been affected, too. In 1997, about US$4 billion in foreign capital was raised through selling stocks (mainly in Hong Kong) and bonds abroad. The financial crisis hitting the Hong Kong stock market affected Chinese “red-chips” particularly badly. Several plans by Chinese firms to list stocks abroad have been postponed or canceled, while international credit ratings of China’s big banks have been lowered.

Third, the RMB resisted pressure to devalue. Although the Chinese government announced that the RMB would not be devalued, there are strong doubts. Chinese leaders and economists agree that an RMB devaluation would have little effect on China’s exports, but may cause a regional currency depreciation cycle, which would hurt the recovery of affected economies. But there is a price to be paid to maintain RMB value. Though devaluation may do little to improve exports, it would adversely affect imports. Thus, the expansion of external demand will have to pull the economy through difficult times. In the first ten months of 1998, there was a surplus of US$38.4 billion in merchandise trade, a 7.8 percent increase over the same period of 1997. But without adequate confidence in the RMB, some export-oriented corporations keep foreign exchange abroad illegally. As a result, foreign reserves grew minimally, from US$140 billion at the beginning of 1998 to about US$145 billion for 1999. Because the RMB is not convertible under capital account, an effective firewall stands against international financial speculation. With a large foreign exchange reserve and trade surplus, the Chinese government probably has enough financial wherewithal to maintain the RMB exchange rate at least until early 2000, if not beyond.

In sum, while China has yet to be directly affected by the worst of the Asian financial crisis, it has nevertheless had an adverse effect on China’s economic growth and social stability. The crisis affects the real economy through the external sector, highlights the fragile nature of the banking system, and exacerbates unemployment problems. With China experiencing a downturn in its business cycle and facing the difficult task of reforming core social and economic institutions, the effect of the crisis could be even more severe.

Policy response

Faced with the shock of regional financial turmoil, China has to deflect its adverse effects as much as possible while doing what it can to help its crisis-hit neighbors. To do so, China has adopted a complex set of policies. First, as an important regional political force, and the second largest economy in East Asia, China realizes its international obligations. China provided assistance totaling US$4.5 billion through the International Monetary Fund (IMF) and bilateral channels to countries including Indonesia, Russia, Thailand and South Korea. Second, to avoid a regional devaluation spiral, China announced it would maintain the current exchange rate of the RMB, although China absorbed severe economic loses from the relative appreciation of its currency.

Domestically, in order to avoid a potential banking crisis and increasing unemployment, China pursued steady economic growth and pushed institutional reform forward. As external demand contributed to 30 percent of China’s growth in 1997, the country maintained a trade surplus to avoid a downturn in its economic growth. Wishing to avoid the protectionist label, China did little to reduce imports. In adjusting export policy to offset the adverse effects of the crisis, but not devaluating the RMB, the Chinese government raised the rebate rate of value-added tax on certain types of export goods such as textiles and steel from 9 percent to 11 percent.

However, external demand is not the path to growth, despite the two percent tax rebate hike. To achieve higher growth targets of seven or eight percent, both monetary and fiscal policy measures have been adopted by the central government to spur domestic demand. For example, the central bank lowered interest rates four times since the onset of the crisis in mid-1997. Loan quotas, an important central bank lever to control money supply, were also abolished and non-state enterprises have been allowed more access to financial resources. As a result, the money supply increased as planned in the first ten months of 1998, with M2, M1 and M0 growing by 16.3 percent, 13.5 percent and 10.7 percent respectively.

With stagnating consumption, the government has emphasized investment to stimulate aggregate demand. An ambitious infrastructure investment program, amounting to RMB100 billion (approximately US$12 billion) for 1998-2000, was announced by state leaders in early 1998. However, this amount cannot meet the substantial demand for project funds, resulting in substantially increased reliance on bank loans. By the end of October 1998, loans outstanding from all financial institutions reached RMB8345.5 billion, 17 percent higher than a year before. Some question whether these infrastructure projects can absorb the loans, and predict that many of these loans will become non-performing.

Other sectors targeted for reform include the housing system, the grain circulation system, state-owned enterprises, the medical insurance system and government downsizing. To assure equal competition among different enterprises, military, armed police and judiciary authorities were to divest themselves from business activities by the end of 1998. China is also in the process of eliminating discrimination against non-state enterprises. An anti-smuggling campaign was launched to improve market order and prevent tariff leakage.


As a result of the crisis and certain Chinese policy decisions, other serious challenges have arisen. On the one hand, housing, medical insurance and government downsizing reforms may have a negative effect on consumer expectations. Banks may be more cautious about lending in a transition period so that interest rate cuts do not stimulate as much credit expansion as expected. Non-state enterprises with little or no credit record still face difficulties in getting loans. On the other hand, the expansion policy may also have an adverse effect on reform. To support the government’s massive investment program, major banks announced an expansive lending plan, which seems contrary to banking reform.

In addition, the ratio of governmental revenue, both budget and extra-budget, to GNP dropped from 39.6 percent in 1979 to 16.8 percent in 1996, a level much lower than that in most other countries in the world. The Asian financial crisis has not helped this situation. Lacking sufficient funds, the government requires state-owned enterprises (SOEs) to share social responsibilities such as hiring extra workers and maintaining current workers’ social safety net in the form of housing, medical insurance and pensions. The SOEs’ extra financial burdens and flaws in enterprise governance mean most of them run in the red, a problem further exacerbated by diminished domestic demand and increased competition abroad. The government has channeled more and more subsidies through the banking system to the ailing state-owned sector. In order to keep from going bankrupt, the leverage rate of China’s SOEs is among the highest in the world. Disturbingly, the bad financial performance of SOEs has pushed the ratio of non-performing bank loans to a level even higher than that of Indonesia or Thailand before the financial crisis. With household deposits being the number one source for bank financing, such a situation cannot be sustained unless the common people confidently place their hard-earned savings in the banks. A serious slow down in economic growth could start a downward spiral in confidence that could lead to a devastating banking crisis.

Finally, as part of the restructuring and reform process, accelerated in part by the financial crisis, the Chinese leadership has encouraged SOEs to begin laying off workers by the tens of thousands. As a result, unemployment is becoming one of the most serious problems in China. Such dramatically increased unemployment may lead to wider social unrest beyond the scattered incidents of worker action recorded in the recent past. With the danwei or “work unit” offering housing, medical coverage and pensions to SOE workers, unemployment or taking a job in the non-state sector can mean losing the long-cherished “iron rice bowl,” especially in the absence of an alternative social safety net from the state. Lacking a social safety net, the government requires some SOEs to keep redundant employees as so-called “laid-off workers” (xia gang gongren) to avoid a sudden surge in urban unemployment, thereby maintaining social stability. The “laid-off workers” continue to receive a basic sustenance income without going to work. The only way for SOEs to sustain such a heavy burden is through further bank subsidies, which in turn brings even greater pressure to bear on an already fragile banking system. The Chinese government realized the fragility of the social safety net and began to setup “Re-employment Service Centers” in most cities. These centers are funded by local governments and pay unemployment insurance to laid-off workers.

In spite of these potential problems, fiscal and enterprise reform policies have worked rather well so far. Several indicators support this view. First, the inconvertibility of the RMB under capital account prevents international speculators from attacking Chinese currency directly, which was the trigger for the financial problems in several neighboring countries. Second, the massive Chinese foreign exchange reserve and large trade surpluses also enhance the confidence of the Chinese currency, and help resist pressures to devalue. Third, the Chinese population has maintained strong confidence in the banking system: by the end of October 1998, overall savings in the banking sector increased by an annual rate of 17.6 percent, with household deposits increasing by 17.1 percent. This suggests strong consumer confidence in the banking sector in spite of concerns voiced in the international community. Fourth, other indicators, such as fixed asset investment, loans, and production of investment goods grew in the latter half of 1998. Industrial output showed some acceleration after August 1998. The official 1998 growth rate of 7.8 percent, while below government targets, was an impressive achievement at a time of regional economic turmoil.

From an economic and social perspective, China faces its most difficult stage since the beginning of reforms in the early 1980s. The government must implement reform while the economy is in the downside of the business cycle. While China can probably maintain the RMB exchange rate and avoid a banking crisis, it needs to improve the coordination of economic development, social stability, and institutional reforms. Long-term reforms are needed to setup a healthy financial system and maintain long-term rapid economic development. The only way to out of potential socio-economic problems is to push ahead with reforms. In this sense, maintaining China’s socio-economic stability is like riding a bicycle: if the rider does not keep up his speed, he will fall over.



In 1998, the film Titanic was the biggest motion picture hit in Japan. Its success in the midst of Japan’s worst economic situation since the end of World War II might stem in part from the fact that millions of Japanese could witness the virtual plight of hundreds of less fortunate people on the screen, and escape-if only for a few hours-the harsh social and economic reality outside the theater.

To put it another way, the current socio-economic condition of Japan is gloomy. While there might be some bright points such as cheaper imports from Asia, overall the situation has been negative. Japan is now under real economic recession (a heisei recession), with the Economic Planning Agency (EPA) admitting that Japan’s persistent recession results from the government’s own failure to deal with the banking crisis swiftly and decisively. Japan expects negative GDP growth for two successive years in 1998 and 1999, a first-time experience for contemporary Japanese; official GDP growth registered a negative 2.8 percent in 1998. The dismal atmosphere in society is penetrated with magazine features on failed companies and massive losses week after week. Japan’s unemployment rate reached 4.9 percent in June 1999, the highest level recorded since the statistic was initiated in 1953. Japan’s start-up rate for new businesses in 1998 was only around 3.7 percent. This is not only well under the U.S. rate of 13.8 percent, but even lower than Japan’s business close-down rate.

A look at some other economic indicators offers a basic illustration of the problems Japan faces in the wake of the Asian financial crisis. As for trade, the lifeblood of the Japanese economy, the situation has been particularly bad. To start with, Japanese exports to Asia have decreased. The rate of change in exports to Asia went as low as negative 18.0 percent for FY1998 (April 1998-March 1999), much lower than the negative 3.8 percent growth rate for exports to the world as a whole. Exports to the Association of Southeast Asian Nations (ASEAN) dropped particularly sharply-26.4 percent. Japanese imports from Asia also decreased. In FY1998, imports from Asia fell by 10.7 percent, while total imports dropped by 11.5 percent.

From a social and political perspective, there has been a heavy impact on the Japanese people in the wake of the crisis. They already felt pessimistic about their future when the Asian crisis occurred because the burst of the “bubble,” prospects for the society’s aging population, fear of increasing unemployment, and the loss of confidence in Japanese institutions (such as the financial sector and the bureaucracy). In fact, it could be said that the Asian economic crisis shocked the Japanese people and packed a greater psychological punch than its actual effects on the Japanese economy.

Additionally, the crisis has affected Japanese perceptions of the market economy and globalization. There is a widespread view that the Asian economic crisis illustrates the volatility of market mechanisms, thus damaging economic and social welfare. A popular practice of the Japanese media is to portray Asian countries as “victims” of market forces, and certainly the crisis presented a lesson in managing market forces, especially short-term capital movements. However, Japanese leaders need to resist interventionist efforts in this regard, which would unduly slow critical steps toward deregulation and structural reform so sorely needed in Japan.

Policy response

Japanese policymakers must tackle two immediate issues, one abroad and one at home. The first involves assistance in the recovery of Asian economies. Japanese are always susceptible to the sentiments of Asian neighbors, and were struck with a sort of guilt when the Asian financial crisis hit in mid-1997. The Japanese felt responsible because their economy plays such a critical role in the overall Asian economic situation (Japan’s US$4 trillion GDP is twice as large as the remaining East Asian economies combined). As a result, the Japanese government has taken serious steps to rescue Korea, Indonesia and Thailand, offering support in the amount of $43 billion in cooperation with the United States and the IMF. In the fall of 1998, Japan further announced a $30 billion package (the “Miyazawa Plan”) to support the economies of selected Asian countries and help restructure weak financial sectors in the region.

Some argue that Japan can help most by stimulating its own economic engine to increase imports from the region. However, the increase of Japanese domestic demand will not be as great as expected, and relying solely on Japanese expansion will not be enough to pull regional economies through. Japan’s share of Asian exports decreased to around 13 percent in 1995 from 20 percent in 1980, while the weight of intra-regional trade grew to 40 percent.

That said, the second immediate policy goal for Japan must be to proceed with its structural reform. The Japanese economic and social systems are, in short, outmoded for an age symbolized by the rapid development of information technology. The Japanese system with such characteristics as lifetime employment and a seniority ranking system, long-term relationships among firms with cross share holdings, and a tax system in favor of larger firms, functioned well to develop manufacturing industries during the “catching-up” era. However, the system is ineffectual and even detrimental today when flexibility and speed count most. One of the lessons learned from the Asian economic crisis must be to control the market mechanism wisely, but that Japan should not slow down or reconsider policies for structural reform.

Nevertheless, these policy measures will not proceed smoothly, and may have some negative effects. For example, even though Japan embarked on various reform efforts in the 1990s-administrative reform, financial reform, political reform, and social reform-the economic crisis in Japan has now caused a backlash. Financial reform, which preoccupied every recent cabinet, has given way, at least temporarily, to a series of Keynsian stimulus packages. Administrative reform seems to have lost its momentum and become overshadowed by economic measures to combat recession and legislative and fiscal measures to rescue the banking system. In the short run, the current crisis has necessitated a larger government role, and “big government” seems revitalized. Regrettably, the reform effort and the economic crisis occurred simultaneously in the mid-1990s, making real reform difficult for both political and practical reasons.

Reform policies are also hindered by the fractious political system in Japan. Following devastating election defeats for the Liberal Democratic Party (LDP) in 1996 and 1998, Japan is now without a strong majority party. In search of stronger political leadership, politicians have sought a realignment of political parties once again. Prime Minister Obuchi and the LDP leadership, seemingly motivated by policy-oriented concerns, seeks to build alliances with Ichiro Ozawa and his Liberal Party. The question is whether this is a welcome sign of swift action or wavering in face of tremendous tasks ahead. At a minimum, it is not reform, but a reversion to the LDP-oriented “1955 System”. Some might argue that firm policies, not political in-fighting, are needed today. But necessity is the mother of invention and politics is a game of majority rule. Bold policy measures can only be taken by the power of a majority, meaning coalition- and consensus-building is all the more necessary. A concrete example of the problem concerns the rescue operation process for the Japanese banking system. It required a full two months before the Diet approved the necessary legislative measures to help the banking sector deal with the impact of the Asian financial crisis. This poses serious questions about the ability of Japan’s leaders to manage future economic crises.


Given these difficult conditions and hesitant responses, the Japanese are justifiably pessimistic about their future. According to a 1998 Asahi opinion poll, 79 percent of respondents are worried about their future, an increase of 10 percent over the previous year. Ironically, 65 percent expect the government to resolve the crisis, but 63 percent are unsure of its reliability. Some 95 percent want reform of the fundamental political and economic systems of Japan.

Japanese people have lost confidence in social, economic and political institutions. The “big is good” myth disappeared with the bankruptcies of big-name companies such as Yamaichi Securities and Long Term Bank and Trust. People have also lost confidence in a government that failed to promptly implement fiscal measures in the 1990s. People were deeply disappointed with the way the political leadership managed the economic downturn.

The crisis has also put Japan’s much-vaunted bureaucracy in the spotlight. Japanese bureaucrats have been harshly criticized domestically and abroad as an obstacle to reform, and a series of corruption scandals in the bureaucracy delivered a devastating blow to its reputation. Their perception about their role has changed considerably thanks especially to the progress of globalization. For example, at the Ministry of International Trade and Industry, protecting existing industries and firms does not mean much any more. What is important is to build an environment where businesses, irrespective of their nationality and sizes, find it worthwhile to locate themselves in Japan. In the process of deregulation, it is inevitable that bureaucrats’ roles will decrease further. It is a sound trend that Japanese politicians, instead of bureaucrats, play a larger role in policy decisions. Even so, the role of bureaucrats remains important because alternatives outside of government, such as think tanks, are not yet well developed.

Japan’s foreign policy activism might also suffer as a result of the Asian financial crisis. As a result of the diminishing degree of confidence among the Japanese people, Japan has become more inward looking. Foreign affairs are no longer a leading topic of conversation. Decreasing national income will force the national budget to be cut across the board for the next several fiscal years, and as a consequence official development assistance (ODA) will be one of the first victims. Serious discussion may question Japan’s annual contribution to the United Nations, which now accounts for 20 percent of the total UN budget. An influential Japanese politician recently noted, “Japan used to think seriously about how Japan should make contributions to the world as a responsible member of the international community. Now we have to think how we should avoid being an obstacle to the world.”

Finally, the socio-economic problems of Japan, exacerbated by the Asian financial crisis, give even greater weight to a perennially troublesome social issue. Japan’s most fundamental challenge is the fact that its population is rapidly aging while fewer children are being born. The total fertility rate (average number of births per woman) dropped rapidly, and stood around 1.39 in 1997. As a result of low fertility and long life expectancy (Japan has the highest life expectancy in the world), the Japanese population is aging at a rate no other country has ever experienced. The share of population aged 65 or over, which was 7 percent in the early 1970s, increased to about 15 percent in 1995. It is expected to reach 27.4 percent in 2025 and 32.3 percent in 2050. The average annual rate of increase of Japanese population is about 0.2 percent nowadays, and will turn negative after 2007. In 2050, the Japanese population will be around 100 million, decreasing by about 27 million. As the Japanese population is aging, people tend not to spend money preparing for an uncertain future. The savings rate remains high even after the government announced a series of economic stimulus packages. Ironically, even in the face of a deflationary economy, the Japanese, still stunned by the “burst bubble,” are more concerned with saving than spending.

In the end, Japan must work to make its social, economic, and political systems and institutions far more flexible and effective. It will be a long process. Even after the worst of the economic situation is past, Japanese people will still face an uncertain future. But hopefully, the Asian economic crisis, to the degree it accelerates reforms to meet these challenges, may have a silver lining for Japan over the long-term.



Regarded as an economic success story, the Republic of Korea (or South Korea) experienced a tremendous setback as the Asian financial crisis reached its shores in November 1997. Per capita GNP plunged from US$10,307 in 1997 to US$6,823 in 1998 as economic growth contracted by 5.8 percent in 1998. Real wages dropped more than 14 percent within a year and the unemployment rate soared up from 2.1 percent in October 1997 to 8.7 percent by February 1999.

Politically, the Asian financial crisis helped precipitate the shift in power to the opposition party in the December 1997 presidential election, bringing Kim Dae-jung to the Blue House. Some have argued that it was the nasty, mud slinging campaign that scared off investors skittish about domestic political stability. Either way, after the crisis, South Koreans sought an explanation. At first, Koreans blamed the IMF or high government officials of the previous government. But before long, they realized that things were not that simple, and soon turned to seeking effective solutions to the crisis.

Confronting this crisis has rais