RDP 9805: The Origin of the Asian Financial Turmoil 3. Why did it Happen?

Like most other financial crises, the Asian financial turmoil was not due to one or two isolated factors. Its multiple origins can be conveniently grouped under three interrelated headings: (i) financial-sector vulnerabilities such as poor credit assessment in some Asian emerging economies concurrent with relatively easy global liquidity conditions; (ii) external sector problems which generated some concern about these economies; and (iii) contagion from Thailand – first to its near neighbours (Indonesia, Malaysia, and the Philippines), thence to some other Asian economies to the north (South Korea, Taiwan, Hong Kong, Japan), and finally much further afield (ranging south to Australia, east to Brazil and west to Russia). For a time, there was even an impact on equity markets in the major industrial countries.

3.1 Financial Sector Vulnerability

Indonesia, Thailand and the Philippines experienced a credit boom in the early 1990s while one developed in Malaysia in the mid 1990s. Table 7 shows that while nominal GDP growth was rapid, bank and non-bank credit to the private sector grew even faster.

Table 7: Bank Lending
Growth of bank credit to the private sector less growth in nominal GDP
  1990–1994 1995 1996
Indonesia 10.4 4.4 5.7
Thailand 10.0 11.1 5.8
South Korea 2.6 2.2 −0.6
Malaysia 3.1 10.5 13.1
Philippines 10.7 27.4 31.5
Singapore 0.8 7.8 5.7
Hong Kong 8.8 8.9 −6.1

Source: Bank for International Settlements (1997, p. 108)

With such an overextension of credit, the ASEAN-4 economies left themselves vulnerable to a shift in credit conditions. When concerns about overheating and the defence of exchange rates (with high interest rates) against strong market pressures led to such a shift, it brought with it slackening economic activity, falls in property prices, and a rising share of non-performing bank loans. Because the credit boom began and ended earlier in Thailand and Indonesia than in Malaysia, the effects were first visible in the former two countries.

Large net private capital inflows (Table 12) provided an important component of the credit boom and a significant portion of the lending was directed to real estate and equities. Exposure to the property market through loans to homebuyers is not particularly high in Asia. What is high is the exposure of banks to property developers, which is a much riskier form of exposure. It has been estimated that total exposure to the property sector accounted for between 25–40 per cent of bank loans in Thailand, Indonesia, Malaysia and Singapore, and even more than that in Hong Kong (JP Morgan's estimates are shown in Table 8). Also, in Thailand, Malaysia and Indonesia this exposure was compounded by high loan-to-collateral ratios. With a lot of office space still under construction, the decline in real property prices in the region may have not finished yet, although some governments are taking action to moderate the fall in property prices.

Table 8: Bank Lending to the Property Sector
Per cent of total bank lending
  Home mortgages
Total property
(Loan as per cent of
Hong Kong 9 40–55 (50–70)
Thailand 8 30–40 (80–100)
Malaysia 14 30–40 (80–100)
Singapore 15 30–40 (70–90)
Indonesia 4 25–30 (80–100)
South Korea 13 15–25 (80–100)
Philippines n.a. 15–20 (70–90)
Australia 32    
Germany 16    
Japan 9    
United Kingdom 56    
United States 30    

Sources: Kamin, Turner & Van't dack (1998) Table 14; Reserve Bank of Australia Bulletin, December 1997 JP Morgan Asian Financial Markets 16 Jan 1998

Data is scarce on banks' exposure to the equity market but the Korean banks are believed to have large holdings of equities and Malaysian banks have reportedly lent large amounts to finance stock purchases. This has contributed to the strains in both these economies.

In several of the Asian economies, financial vulnerability was exacerbated by banks and/or their customers trying to reduce their funding costs by borrowing in foreign currencies and at short maturities.

In Thailand there were several incentives for undertaking this kind of foreign borrowing strategy. Firstly, interest rates abroad were much lower (about half as high) than in Thailand. Secondly, the long-running stability of the baht relative to the US dollar presumably led borrowers to believe that the risk of baht devaluation was low. While the exchange rate between the US dollar and the yen was subject to substantial fluctuation, only a sharp appreciation of the yen would wipe out the savings from very low Japanese interest rates. Thirdly, as part of the government's effort to promote Bangkok as a regional financial centre, the Bangkok International Banking Facility had been established in 1993, with a mandate (and special incentives) to borrow abroad in foreign currency and to lend to other borrowers in the region (so-called ‘out-out’ operations); in the event, while facilitating such foreign borrowing, most of the proceeds appear to have been lent to Thai entities (‘out-in’ operations). Finally, in two earlier banking crises, the government had a track record of intervening to support troubled financial institutions and of not allowing banks to fail; in other words, an official safety net might have been expected to reduce if not eliminate risk.

Currency mismatching by companies was the greater problem in Indonesia. Once the rupiah was floated, belated efforts by Indonesian firms to hedge their large short foreign-currency position in the market helped accelerate its decline. This established a vicious circle, whereby the currency weakened further, prompting more defensive selling.

In South Korea, the vulnerability arose from the short-term foreign currency borrowings by banks and the chaebol. In Malaysia and the Philippines, the scale of foreign borrowing over the 1990s was also considerable, but on the whole, maturity and currency mismatches were apparently kept under better control than in Thailand or Indonesia.

Table 9 provides several measures of liquidity and currency mismatches for the Asian emerging economies (as well as some other developing countries). In short it supports the view that South Korea, Thailand and Indonesia were particularly vulnerable to liquidity and currency mismatches in the run-up to the recent turmoil.[9] Thailand and South Korea would look even more vulnerable in these comparisons if commitments in forward markets or loans to commercial banks were netted off the gross reserves used in such ratios.

Table 9: Liquidity and Currency Mismatch Variables
Ratios; end June 1997
  Broad money /
international reserves
Short-term external
debt to international
External debt:
short-term /total
Borrowings from
overseas banks:
short-term /total
(a) (b) (c) (d)
Indonesia 6.2 1.6 0.2 0.6
Thailand 4.9 1.1 0.5 0.7
South Korea 6.2 3.0 0.7 0.7
Malaysia n.a. 0.6 0.4 0.6
Philippines 4.9 0.7 0.2 0.6
China 8.2 n.a. n.a. 0.5
Taiwan 5.8 n.a. n.a. 0.9
Argentina 3.6 1.1 0.2 0.5
Brazil 3.5 0.7 0.2 0.6
Chile 1.8 0.4 0.3 0.4
Mexico 4.2 1.3 0.2 0.5

Sources: (a) IMF International Financial Statistics April 1998 and Taiwan Financial Statistics February 1998. ‘Broad money’ is ‘money plus ‘quasi-money’ (lines 34 plus 35). International reserves are total reserves less gold (line 1l.d.).
(b) and (c) World Bank (1998)
(d) BIS Maturity, Sectoral and Nationality Distribution of International Lending, First Half of 1997, January 1998.

The conclusion that it was the composition of foreign borrowing – and not so much the total external debt burden – that underpinned the vulnerability of the crisis countries is reinforced by the external debt figures shown in Table 10. In terms of external debt to GDP Thailand and the Philippines had higher burdens than their neighbours but those were not far outside the range experienced by many emerging economies. Similarly, only Indonesia among the five most adversely affected economies has a high debt burden relative to exports (and still below that of both Argentina and Brazil). The figures on the currency composition of external debt shown in Table 11 likewise reinforce the point that the vulnerability of the crisis countries was not tied to the foreign-currency denomination of external debt per se, but rather to the imbalance between short-term foreign-currency denominated liabilities and liquid foreign-currency denominated assets (international reserves).

Table 10: External Debt Burden
  Total external
debt as per cent
to 1996 GDP
Total external
debt as per cent
to 1996 exports
1997 repayments
due as per cent
to 1996 exports
Indonesia 49 189 67
Thailand 59 154 90
South Korea 23 72 37
Malaysia 38 42 19
Philippines 59 140 61
Singapore 11 n.a. n.a.
Hong Kong 21 15 7
China 16 n.a. n.a.
Argentina 30 320 133
Brazil 15 n.a. n.a.
Chile 31 117 14
Mexico 44 139 46

Source: Debt and repayments (i.e. short-term debt plus long-term debt repayments due) from OECD External Debt Statistics 1997, GDP and exports from IMF International Financial Statistics, March 1998 (lines 99b, 90c). China's GDP from national source.

Table 11: Currency Denomination of Foreign Debt
Per cent of total long-term debt (1996)
  US$ Yen Major European Other(a)
Indonesia 24 35 11 30
Thailand 32 45 4 19
Malaysia 56 28 4 12
Philippines 34 35 3 28
China 65 16 2 17
Argentina 58 9 18 15
Brazil 69 6 8 17
Chile 46 9 5 40
Mexico 68 8 7 17

Note: (a) includes SDRs and other multi-currency.

Source: World Bank (1998)

These credit booms, asset price bubbles and liquidity/currency mismatches were unlikely to have gone so far were it not for the accompanying long-standing deficiencies in financial-sector supervision. Common problems in emerging economies include lax loan classification and provisioning practices.[10] ‘Connected lending’ (making loans to major shareholders, bank directors, managers, and their related businesses) was allowed to flourish, with the concomitant dangers of concentrated credit risks and lack of impartial credit decisions. Too many banks were owned by governments and became the ‘quasi-fiscal’ agents of governments, providing an oblique mechanism for channelling government assistance (off-budget) to ailing industries. In some cases this directed lending was also undertaken by privately owned banks. With the exceptions of Hong Kong and Singapore, the riskiness of banks' operating environment was not matched by an appropriate level of capital. History led to the strong expectation that depositors and creditors would get bailed out should banks get into trouble. In the face of strong political pressures for regulatory forbearance, bank supervisors lacked the mandate to resist. Adding to these problems, the quality of public disclosure and transparency was questionable. There have been sharp rises in reported non-performing loans recently; although many private sector estimates are higher still.

Of course, every borrower of foreign funds in these economies had a corresponding lender overseas. These lenders' enthusiasm for emerging markets recovered surprisingly quickly after the Mexican crisis. Indeed 1996 was a record year for private net flows to emerging economies. Spreads on emerging economy bonds narrowed markedly between 1995 and mid 1997; according to Cline and Barnes (1997) by more than can be explained either by upgradings by ratings agencies or by fundamentals. Moreover, maturities were extended and loan covenants were watered down. East Asian economies accounted for half the top ten recipients of private capital flows. (Table 12 and Figure 10)

Table 12: Five Asian Economies: External Financing
Indonesia, Malaysia, Philippines, Thailand, South Korea; US$ billions
  1994 1995 1996 1997(e) 1998(f)
Current account −25 −41 −55 −27 31
Private flows, net 38 79 97 −12 0
direct equity 5 5 6 6 7
portfolio equity 7 11 12 −4 10
bank lending 23 50 56 −27 −20
other private lending 2 14 23 13 3
Official flows, net 7 5 −2 30 26
International financial institutions 0 0 −2 23 23
Bilateral creditors 8 6 0 8 3
Other flows (balancing item) −15 −29 −22 −31 −5
Reserves (− is increase) −5 −14 −18 40 −52

Source: Institute of International Finance (1998)

Figure 10: Concentration of Private Capital Flows
10 largest recipients; US$ billion 1990–1995
Figure 10: Concentration of Private Capital Flows

Source: World Bank (1997)

The proximity of Tokyo, a large financial centre offering extremely low interest rates, also proved a temptation. The combination of weak economic activity, a huge stock of bad loans in the banking system, and a public antipathy to bailing-out banks, seemed to point to the continuation of low interest rates there. (The large share of bank lending coming from Japan is shown in Table 4 and the high proportion of debt denominated in yen in Table 11.) Furthermore, as had been the case with Mexico, the ASEAN-4 economies were generally regarded by lenders as in the first tier of sovereign borrowers among emerging markets. There were certainly some good reasons for this; over the previous decade they had been the star performers in terms of economic growth, plugged themselves into global markets, and had high saving and investment rates, and enviable fiscal positions.[11] The modest levels of public debt may have (falsely) assured lenders that if local financial institutions encountered troubles, the public sector had the capacity to mount a prompt and comprehensive rescue. All these positive attributes led bankers to overlook their weaknesses almost until (or in some cases after) the crisis hit.

3.2 External Sector Problems

As Table 13 shows, Thailand's current account deficit reached 8 per cent of GDP in 1996, with the other ASEAN-4 countries also having significant deficits.

Table 13: Saving and Investment
Per cent to GDP; 1996
  Current account
budget balance
Indonesia −3.8 1.2 28.7 32.1
Thailand −8.0 2.3 33.6 42.5
South Korea −4.8 0.1 34.3 38.2
Malaysia −6.3 0.7 37.8 41.5
Philippines −4.5 0.3 19.6 24.2
Singapore 15.2 7.0 51.3 35.1
Hong Kong (a) (a) (a) 32.4
Taiwan 4.0 −0.7 25.9 21.2
Argentina −1.4 −1.8 n.a. 17.6
Brazil −2.5 n.a. 13.5 19.1
Chile −4.1 2.2 22.6 27.7
Mexico −0.6 n.a. n.a. 20.9
Australia −4.1 −1.0 17.5 20.6
Germany −0.6 −2.1 n.a. 22.6
United Kingdom 0.0 −4.7 16.3 15.8
United States −1.9 −1.5 16.0 17.2

Notes: (a) Full balance of payments and timely GNP statistics are not compiled yet for Hong Kong but Ma and Hawkins suggest the current account may have been in surplus in 1993 and in deficit of the order of 1 per cent of GDP in 1994 in ‘Hong Kong's Balance of Payments: Some Research Estimates’ Hong Kong Monetary Authority Quarterly Bulletin February 1997. Using GDP as a proxy for GNP, saving/GDP is 31%. Government accounts are not given in the IFS but the budget is in surplus.

Sources: IMF International Financial Statistics April 1998; Taiwan data from domestic authorities; current accounts are JP Morgan estimates for Indonesia, Malaysia and Philippines.

However, these current account imbalances were widely viewed as benign (at the time) in two respects. Firstly, there was a belief (known variously as the ‘Lawson doctrine’, ‘Pitchford critique’ or ‘consenting adults view’) that current accounts were only a concern if they reflected public sector deficits. This was not the case in the ASEAN-4 economies. Secondly, the funds borrowed offshore were being employed to increase investment (rather than consumption), thereby building the potential capacity to service the debts. In both these dimensions, Asian current account deficits were said to be more sustainable than those in Latin America.

Gradually, however, this sanguine interpretation was challenged on at least five counts;

  • The quality rather than just the quantity of investment assumed greater importance. Investment ratios of 30–40 per cent plus began to look less attractive when much of it was directed toward speculative activities such as golf resorts and expensive condominiums, industries where overcapacity was threatening or over-ambitious infrastructure projects.
  • Real effective exchange rates pointed to some deterioration in competitiveness in much of emerging Asia in 1996 (Figure 3). These overvaluations were not particularly large but, when accompanied by large imbalances in the balance of payments, they nevertheless increased vulnerability.[12]
  • Merchandise export receipts slowed in 1996 (Figure 10). In Thailand, they were almost unchanged in 1996, after rising 24 per cent in 1995. While it was acknowledged at the time that some of the slowdown was attributable to temporary factors, such as a slowdown in global trade and an inventory glut in the worldwide electronics industry (which was especially important as electronics account for a large share of exports in many Asian emerging economies) the export slowdown did raise questions about longer term projections.
  • Competition from China became more of a concern. More specifically, some analysts detected a shift in perceived regional comparative advantage toward China and away from the ASEAN-4 economies.[13] Closer analysis by Fernald, Edison and Loungani (1998) suggests this concern may have been misplaced. They conclude that China's export growth is similar to that in other developing Asian economies, rather than gaining at their expense.
  • Overproduction and intense export competition in certain industries was seen as a looming threat to the sustainability of Asian external deficits. Industries for which concerns were voiced about global overproduction included some (automobiles, memory chips, petrochemicals, steel, cement, wood products, frozen chickens, etc) of importance for the Asian economies.

3.3 Contagion

The factors discussed in the last two sections provide an explanation of why some Asian emerging economies and currencies were vulnerable. But most of these factors did not appear overnight in July 1997. Why did so many Asian currencies come under attack in so short a space of time? Here some kind of contagion must surely be part of the answer.

Past empirical work on this topic has established that contagion is typically greater during turbulent periods than more tranquil times, that it operates more on regional than on global lines, and that it usually runs from large countries to smaller ones.[14] In this last respect, the Asian currency crisis is unusual, in that it originated in a relatively small country (Thailand) and spread to a wide set of economies, both large (Korea, Japan, Brazil, Russia) and small.

There are three ways contagion might spread. The first is via direct linkages, the second is through competitive devaluations, and the third is through signalling. The first of these does not seem to provide a good explanation for the recent Asian experience. Table 14 shows some indicators of the importance of the bilateral relationship with Thailand. In terms of their bilateral links, Malaysia, Singapore, Taiwan and Hong Kong would have been more vulnerable than Indonesia and South Korea; but this is not consistent with the observed impact of the crisis across economies (e.g. the size of currency and equity declines, the downward revision of 1998 growth forecasts).

Table 14: Bilateral Relationships with Thailand
Flying time
Export similarity
Malaysia 1,180 125 4.6 2.5 0.40
Singapore 1,430 135 3.0 3.7 0.43
Taiwan 2,530 330 3.1 4.2 0.50
Hong Kong 1,730 160 0.4 <2 0.50
Philippines 2,210 195 1.8 <2 0.39
Indonesia 2,310 295 2.2 1.3 <0.4
South Korea 3,720 440 1.8 1.3 0.44

Sources and definitions: Distance and flying time: kilometres between capital cities and flight times (minutes) on common flights between them. Source: Microsoft, Bloomberg. Export market: per cent share of country's exports which went to Thailand in 1996. Source: IMF Direction of Trade Statistics. 1997 Telephone calls: Incoming calls to Thailand in millions of minutes as a percentage share of all international calls from that country. Source: TeleGeography Inc TeleGeography 1997/98: Global Telecommunications Traffic Statistics and Commentary October 1997 Export similarity: A measure of the similarity of the product composition of exports with those of Thailand, and hence, its role as a competitor in world markets, taken from Williamson (1996) using a 4-digit industry classification and 1992 data.

The second means by which contagion could arise is through the competitiveness dynamics of devaluation. As one country after another in a region succumbs, those countries surviving find themselves less competitive which in turn makes their currencies more vulnerable to speculative attack, a sort of ‘domino theory’ of devaluations.[15]

A third possible cause of contagion is signalling; international investors were startled by events in Thailand, leading them to reassess the creditworthiness of all Asian borrowers.[16] They found a number with similar weaknesses, in kind if not in degree, and thus wrote the other economies down as well.

There are at least two reasons for favouring this third characterisation. One is that markets appeared to be ‘asleep at the wheel’ in terms of monitoring latent risks in emerging Asian markets prior to the Thai crisis.[17] Eschweiler (1997), for example, documents that interest rate spreads gave no warning of impending difficulties for Indonesia, Malaysia and the Philippines, and produced only intermittent signals for Thailand. Similarly, Wolf (1997) comments ‘two leading credit rating services, Moody's and Standard and Poor's failed to downgrade long-term debt ratings of Indonesia, Malaysia or Thailand in the year and a half to June 1997. Instead, downgradings followed the crisis – and exacerbated it’. (Figure 11).

Figure 11: Country Credit Ranking
Standard and Poors: long-term foreign currency rating
Figure 11: Country Credit Ranking

Source: Bloomberg

A second reason for favouring the third characterisation is based on some calculations involving ranking seven Asian emerging economies according to fourteen fundamentals identified as important in the literature.[18] A simple average ranking, which places Thailand (the first economy to get into trouble) as most vulnerable, indicates Indonesia (the economy subsequently worst affected) as second-most vulnerable. Fundamental-based rankings correspond much more closely to the observed impact on economies than do rankings of the economies on the basis of their bilateral relationship with Thailand.


Calvo and Goldstein (1996) show that such liquidity and currency mismatches made Mexico more vulnerable to attack in 1994 than its Latin American neighbours. [9]

See Goldstein (1997). [10]

See Grenville (1998). [11]

Empirical analyses of early-warning indicators of currency crises in emerging economies (see Goldstein and Reinhart (1998), Kaminsky, Lizondo and Reinhart (1997) and IMF (1998)) find that real exchange rate overvaluation has historically been among the best performing crisis signals. [12]

For example, Thurow (1998) asserts the ASEAN-4 economies swing from trade ‘surplus to deficit is directly traceable to mainland China's decision to concentrate on increasing exports as the engine of its economic growth’. Some others emphasised the rising share of China (versus the static share of the ASEAN-4 countries) in Japanese FDI. Other examples are cited by Fernald, Edison & Loungani (1998). [13]

See Calvo and Reinhart (1996). [14]

Some (e.g. Thurow 1998) argue that the initial trigger for the devaluations in the region was the Chinese official devaluation in January 1994. However, because of the large share (perhaps 80 per cent) of transactions conducted at the market rather than the official rate before the two were unified by a devaluation of the official rate, the true devaluation was much less. See Liu, Noland and Robinson (1998) and Fernland, Edison and Loungani (1998). In addition the latter show that export competition between China and the rest of emerging Asia was much greater in 1989–93 than in 1994–96. [15]

The impact of the news in Thailand was exacerbated by how much of it was received so quickly – the loss of reserves, the float, the approach to the IMF, the problems in the financial system etc. The fact that the rapid growth in the economies was termed by many ‘the Asian miracle’ implied that its basis was not that well understood, which perhaps exacerbated the tendency to panic when it seemed to be faltering. [16]

See Radelet and Sachs (1998) for a comprehensive discussion of how unexpected was the Asian crisis. [17]

The fundamentals used were excess credit growth, the ratio of short-term external debt to international reserves, the ratio of broad money to reserves, the ratio of external debt to GDP, the banking sector's risk-weighted capital ratio, the share of non-performing loans, the importance of state-owned banks, bank credit-ratings, the ratio of the current account to GDP, international reserves, the extent of the 1996 export slowdown and three measures of the overvaluation of the real effective exchange rate. Data on most of these factors are presented in Figures 3, 4 and 9 and Tables 7, 9, 10 and 13. Details of the calculations are available from the authors. Another result of this exercise worth mentioning is that Hong Kong and Singapore consistently rank higher on the fundamentals than do the other economies, suggesting there were good reasons for their being less affected. [18]