The Asian Financial Crisis (Asian Contagion) started unfolding itself in 1997 when the Thai Government was forced to withdraw the “Fixed Exchange Rate System” and established the “Floating Exchange Rate System”. As a result, currency markets first failed in Thailand which had a domino effect on countries throughout East Asia. South East Asian stock markets and import revenue declined massively due to this economic upheaval (especially in “Tiger Economies” i.e. Thailand, South Korea, Malaysia, Indonesia, Singapore and Philippines). In this article, we will try to delve deeper into what exactly caused this crisis and more importantly why India remained unaffected in this economic downturn. Let’s explore!
How did it start in Thailand?
First country that marked the beginning of “Asian Contagion” was Thailand. So, let’s see how the economic bubble was created over the years and busted in Thailand in the summer of 1997.
Thailand was categorized as one of the “Tiger economies” till 1995 as it had a GDP growth rate of 8% on average. But it was a kind of hollow growth that popularized Thailand with the name “Toothless Tiger”. The reasons for such colossal growth especially from the period of 1990 were recession in European countries, stagflation in Japan, a policy of market deregulation & liberalization of capital account followed by Thai Government, fixed exchange rate regime under Thailand, savings to GDP ratio as high as 33.5% and fiscal surplus too.
All the above stated facts exaggerated the investment process in Thailand (both domestic and foreign). The net capital inflows were at an all time high of US $14.239 billion by 1995 in Thailand. The confidence of foreign investors also shot up the stock markets by approximately 175%. All went well except the channelization/utilization of hot money (another name for capital). A major chunk of the capital lies within non-productive sectors (that means those sectors which produced non-exchangeable goods for international trade) like real estate. This acts as a limiting factor in the growth of the Thai economy as real estate is a non-productive sector and it has limited market demand. By 1997, houses and buildings lined up but there was not the demand for the same which increased the commercial vacancy rate to 15%. This made the business of real estate unprofitable. The boom in real estate from 1990 -1995 (popularly called the Asian Economic miracle) settled down by 1997.
In late 1990’s only, US Federal Bank decided to put upward pressure on the interest rates to tackle the inflationary trend in the US economy. This incident raised the demand for the US dollar and the baht starts to fall. But due to the presence of the “Fixed exchange rate system” in Thailand, the government try to stabilize the exchange rate. The fall in world demand for the semiconductors (Thailand’s major export item) from 1996 and continuous appreciation in dollars from 1995 affected the Thai’s forex reserves badly. On 2nd July 1997 government rant out of forex reserves and forced to introduce the “Floating Exchange rate system”. This further worsened the problem of devaluation of the Thai baht.
Such massive devaluation had serious repercussions like an increase in Non-Performing Assets (both domestic and foreign). “Somprasong” was the first company that failed to meet the foreign debt obligation on 5th February 1997. Even government efforts couldn’t do anything as they were “Out of foreign reserves”.
This is how the bubble busted in Thailand. Now we will see how it spread to other South East Asian Countries.
The Impacts on other countries:
As a result of unpegging the Thailand Baht with US Dollars, a lot many East Asian countries also suffered. The International stocks fell by 60 percent. The most affected countries were Thailand, Indonesia, South Korea while some countries who were also affected were Malaysia and Philippines.
Thailand: The Thailand baht depreciated by 41% and the stocks declined by (-) 53%. The US Dollar investments fell by 72%. This means that if you have made an investment of $100 in the beginning of 1997, you can get back only $29 in the end of that year. In the year 1998, the GDP of Thailand, which previously had a growth rate of 9%, fell by 10.4%.
Indonesia: The Rupiah, which is the Currency of Indonesia, had strengthened respective to dollars, in the preceding years. Before the crisis, the exchange rate was 2600 rupiah to one dollar. But, after the crisis, the scene changed. The rate plunged by 83% that is, it shot down to 14000 rupiah to one dollar, on 23rd January 1998. However, the rate was almost stabilized to 8000 rupiah to a dollar on 31st December. Indonesia lost 13.2% of GDP that year. The Jakarta Stock Exchange, Indonesia experienced the historic fall in September. The stocks fell by 58%. IMF financed around $23 billion for its recovery.
South Korea: The weak government regulations on capital borrowing made South Korea a victim of this crisis. South Korean’s Won declined to the extent of 35%. The loss in value of US Dollar denominated investments was around 71%. The GDP in the year 1998 fell by 5.8% compared to 1997. The national debt-to-GDP ratio has almost doubled, from 13% to 30%.4
Philippines: On the very night of July 2, Philippines central Bank raised the exchange rate from 15% to 32% in order to protect Peso, their official currency. But peso dropped by 46.8%, that is from 26 pesos per dollar to 53 pesos per dollar. Their GDP declined by 0.3%, but, they regained their position in 2001.
Economic Reforms and the role of IMF:
The severity of the economic crisis called for urgent outside intervention. Since the countries that were affected the most were among the Tiger Economies of Asia, a lot was on the line. The International Monetary Fund, or the IMF, had a key role to play in restoring financial market confidence and stability in these countries. IMF’s strategy to address the crisis mainly had three components:
Financing: Around $35 billion (along with $85 billion provided by other multilateral and unilateral sources) were provided by the IMF for reform programs in Indonesia, Korea, and Thailand. In addition to this, actions were taken and promote inflows and prevent private capital outflows.
Macroeconomic policies: Monetary policy was tightened and interest rates were increased to stop the collapse of the countries' exchange rates and to prevent a spiral of continuing depreciation and inflation. This monetary tightening was supposed to be temporary. The interest rates were lowered once the markets in those countries had stabilized.
Structural reforms: Several structural reforms were implemented to address the weakness in the corporate and financial sectors of the affected countries. For example, the ceiling on foreign investments was raised and insolvent banks and financial institutions were allowed to fail. Additionally, steps were taken to reverse the effects of the social consequences of the crisis as well.
These policies, however, were initially less successful in restoring the economies in all three countries. This was because there were initially hesitations in the implementation of the programs and uncertainty over the packages. Even after all the efforts, the foreign exchange rates were still plummeting and huge capital outflows were still being made. The situation showed no signs of improvement. This again led to a large fall in domestic spending, especially private investment.
However, by 1998, the financial markets in Thailand and Korea had begun to stabilize, and significantly later, in Indonesia as well. By mid-1998, the exchange rates had started falling along with the interest rates, and by the early 2000s, almost all the affected countries had recovered and were able to repay their debts to the IMF.
What Thailand could have done?
Rapid growth in Thailand had attracted large amounts of foreign direct investments from people abroad. Had Thailand implemented a system of Partial Capital Account Convertibility, although the number of investments would’ve been lower, the economy would’ve been in a much more stable condition. Also, trying to keep the Thai Baht pegged to the US Dollar led to the country’s foreign reserves drying up within a matter of days. Having the Thai Baht float, like the eventually had to, would have prevented such a situation.
Finally, the flaws in the nation’s financial sector framework cooked up the macroeconomic imbalances in Thailand which gave rise to “Asian Contagion”. The political intervention in the working of “Bank of Thailand” should have been limited. The constraints on the foreign reserves can be better analyzed by the independent central bank as compared to the puppet bank.
How India got spared:
While all the other countries in South-East Asia were under attack by the economic crisis, India, fortunately, was not affected at all. This was all thanks to India’s strict control on the free movement of capital.
Most of the tiger economies had capital account convertibility and had rapid economic growth due to the short-term capital flows. India, on the other hand, had a system of partial capital account convertibility. This meant that although investors could bring in or take out money for capital transactions, they were required to take permission from the government before doing so. Having such severe capital account restrictions prevented the inflow and outflow of short-term portfolio investments through the country, thus saving India from the sudden appreciation of the US dollar.
Added to this is the fact that unlike the Thai Baht and the Indonesian Rupiah, the Indian Rupee wasn’t hard pegged to the US Dollar. This acted as an additional shock absorber for the economy as India didn’t have to keeping expending its foreign reserves to keep the value of the India Rupee constant.