Causes and Consequences of the Asian Financial Crisis: An In-Depth Analysis

1. International Financial Crises What happened in Asia? Globalization, 17.195 R. Bonoan & J. Shapiro November 21, 1999

2. Causes of foreign capital inflow • Expansionary monetary policy in money centers • Excess world liquidity (world capital glut) • Financial deregulation • Higher interest rates relative to money centers • Liberalization of capital account • Government policies toward the financial system • Bank-centered financial system • Weak bank supervision • Moral hazard (Banks used as instrument of public policy and too big to fail) • Government macroeconomic policy • Fixed exchange rate • Loose fiscal policy (persistent budget deficits) • Macroeconomic vulnerability • High relative inflation caused by expansion of money supply • Real exchange-rate appreciation • Widening of current account deficit Inflow of foreign capital • Misallocation of capital • Overinvestment • Asset price bubble • Corruption • Government policies toward foreign capital • Capital account liberalization biased toward short-term capital • Foreign capital used to finance public debt • Debt Maturity Structure • Accumulation of short-term debt denominated in foreign currency • Triggers • Depletion of foreign exchange reserves • Economic vulnerabilities revealed • Credibility of fixed exchange rate undermined • Financial vulnerability • To banking crisis • To public debt crisis International Financial Crises 1. Vulnerabilities & Triggers • Triggers • Economic vulnerabilities revealed • Credibility of fixed exchange rate undermined • Crisis • Speculative attack on currency • Capital outflow • Spectre of public debt default

3. 2. International Financial Crises Government Response and Feedback Mechanisms • Depletion of foreignexchange reserves • Credibility of fixed exchange rate further undermined • Crisis • Speculative attack on currency • Capital outflow • Spectre of public debt default • Exchange rate pegunder pressure • Macroeconomic imbalances • Competitive devaluation • Financial system further weakened • High interest rates force borrowers into default • Specter of bank bailout • Credibility of fixed exchange rate further undermined • Incentives to devalue increase • Credibility of fixed exchange rate further undermined • Domestic economy weakens • Bankruptcies/bank collapses • Increasing unemployment • Rising political unrest Government raises domestic interest rates

4. Causes of foreign capital inflow • Expansionary monetary policy in money centers (US, Europe, and Japan) • Excess world liquidity (yen bubble) • Financial deregulation in Europe • Higher interest rates in Asian countries relative to money centers • Asian countries liberalize capital accounts • Government policies toward financial system • Bank-centered financial system • Weak bank supervision • Moral hazard (Banks used as instrument of public policy and too big to fail) Inflow of foreign capital • Misallocation of capital • Overinvestment • Asset price bubble (real estate) • Corruption • Financial vulnerability • To banking crisis • Public debt crisis • Triggers • Economic vulnerabilities revealed (bank collapses; corruption exposed) • Credibility of fixed exchange rate undermined • Crisis • Speculative attack on currency • Capital outflow The Asian Financial Crisis 3. “Crony Capitalism”

5. “CronyCapitalism”

6. Causes of foreign capital inflow • Expansionary monetary policy in money centers (US, Europe, and Japan) • Excess world liquidity (yen bubble) • Financial deregulation in Europe • Higher interest rates in Asian countries relative to money centers • Asian countries liberalize capital accounts Inflow of foreign capital • Government policies toward foreign capital • Capital account liberalization biased toward short-term capital • Debt Maturity Structure • Accumulation of short-term debt denominated in foreign currency • Financial vulnerability • To banking crisis • Triggers • Economic vulnerabilities revealed (collapse of chaebol; revelation of true short-term debt burden) • Credibility of fixed exchange rate undermined The Asian Financial Crisis 4. Short-term Capital Flows (South Korea) • Crisis • Speculative attack on currency • Capital outflow

7. Short-term Capital Flows

8. Causes of foreign capital inflow • Expansionary monetary policy in money centers (US, Europe, and Japan) • Excess world liquidity (yen bubble) • Financial deregulation in Europe • Higher interest rates in Asian countries relative to money centers • Asian countries liberalize capital accounts • Government macroeconomic policy • Fixed exchange rate (dollar peg) • Macroeconomic vulnerability • High relative inflation caused by expansion of domestic money supply • Real exchange-rate appreciation (also because dollar strengthening) • Widening of current account deficit Inflow of foreign capital • Triggers • Depletion of foreign exchange reserves • Economic vulnerabilities revealed (real estate bubble bursts and Bangkok Bank of Commerce fails) • Credibility of fixed exchange rate undermined The Asian Financial Crisis 5. Macroeconomic Fundamentals (Thailand) • Crisis • Speculative attack on currency • Capital outflow

9. Macroeconomic Fundamentals

10. Conclusions • Multiple variables to consider • Variance across countries • Not all factors were present in all countries • Triggers were important • Vulnerabilities not sufficient to cause crisis • Several paths to crisis • Was the crisis inevitable? • How much weight should be assigned to each path?