Assignment 1999-2000 in

INTERNATIONAL FINANCE

For

Professor Nick Sarantis

Title: ([DPLQH WKH SRWHQWLDO FDXVHV RI WKH  $VLDQ )LQDQFLDO

&ULVLVDQGFRQVLGHUWKHLPSOLFDWLRQVRIWKLVFULVLVIRUWKHUHVWUXFWXULQJRI

WKH ,QWHUQDWLRQDO 0RQHWDU\ 6\VWHP DQG IRU LQWHUQDWLRQDO ILQDQFLDO

UHJXODWLRQ

Written by Konstantinos Kostoulas 9910284

Msc in International Banking and Finance (F/T)

(3,000 words)
 2

CONTENTS:

Sections:

a) The 1997 Asian financial Crisis: Introduction..……………….……Page 3

b) A short chronology of the Crisis …………...…………….………….Page 3

(Chart 1): Stock Market Indices in U.S dollars and days of stock market jitters…………..Page 4

(Chart 2): Emerging Market Yield spreads: The case of Asia……………………….….Page 5

c) Causes of the crisis………………………………….……………...…..Page 5

(Table 1): Capital Flows in the Asian Economies…………………..………………..Page 6

(Chart 3): Balance of capital and financial account over GDP….……………………...Page 7

(Chart 4): Yen-Dollar Exchange Rate, January1992-December1997………...…..…..…...Page8

(Table 2): Importance of International Trade for various countries, 1996…….……….....Page 9

d) Implications of the crisis for the restructuring of the International Monetary

System ………………………………………………………………..……….Page 10

e) Implications of the crisis for international financial regulation………..Page 11

Appendix: High-Frequency Contagion in the Exchange and Equity Markets…Page 13

Regression Results Table (Granger causality in real exchange rates explains contagion)……..Page 14

References to the Literature……………………………………………..Pages 15,16

 3

a) Introduction

Within a few months in late 1997, a number of East Asian countries, most of which
had previously had an enviable record of years of rapid growth and apparent financial
stability, were hit by financial and exchange rate crises.
Financial and corporate sector weaknesses played a major role in the Asian crisis in
1997. These weaknesses increased the exposure of financial institutions to a variety of
external threats, including declines in asset values, market contagion, speculative
attacks, exchange rate devaluations, and a reversal of capital flows. In turn, problems
in financial institutions and corporations worsened capital flight and disrupted credit
allocation, thereby deepening the crisis. The five countries that were mainly hit by the
crisis were Korea, Malaysia, Indonesia, Thailand, and the Philippines.
Between July 1997 and January 1998, Indonesia’s rupiah was depreciated by 432%,
rising from 2430 to 12950 rupiah per U.S. dollar, and its stock price index declined by
54%. Between January and December 1997, the Korean Won was depreciated by
121% and its composite stock price index declined by 50%. The value of Thailand’s
baht and composite stock price index declined by 139% and 52% during a similar
period (Chart 1).
b) A short chronology of the Crisis1
The official onset of the Asian crisis is marked by the devaluation of the Thai
currency on July 2, 1997.However, the speculative attack against some of the Asian
currencies starts earlier on. The first notable pressure on the Thai currency occurs in
July 1996, following the collapse of the Bangkok Bank of Commerce and the
injections of liquidity by the Bank of Thailand to support the financial system. The
attack peaks on May 14, 1997 amid concerns of political instability, with the stock
market declining almost 7 percent. The subsequent resignation of Thailand’s Finance
Minister, who was a supporter of the fixed peg leads to an 11 percent decline of the
stock market. The suspension of operations of 16 finance companies increases worries
about the fragility of the financial sector in Thailand and leads to further withdrawal
of foreign funds, which in turn trigger the floating peg of the Thai currency on July 2.
The abandonment of the peg in Thailand posed similar effects on Philippines and
Malaysia.
With the crisis still confined to these countries, volatility in financial markets
increases dramatically. By August 1997,the crisis has engulfed Indonesia, with the
local currency starting to float on August 1997.In October, the currency crisis spreads
to Taiwan, with the devaluation of the Taiwanese dollar creating doubts about the
sustainability of the Hong Kong dollar peg. Tension escalates in the region and in a
matter of days, the Hang Seng index loses about 30 percent. The currency crisis
quickly spreads to Korea, with stocks collapsing on November 7.On December 11
Korean financial markets experience further declines, following Moody’s downgrade
of Korea’s foreign currency bonds (Chart 2). On December 19,the Japanese stock
market collapses. By early January, Indonesia adds to the ongoing panic by refusing
to implement its promised structural reforms. On January 19,the IMF makes clear that
it is not going to support the Indonesian plans to peg the Indonesian currency to the
dollar, which triggers further uncertainty and deepens the crisis.

1
A more detailed chronology of the crisis can be found in Kaminsky and Schmuckler (1999), What
Triggers Market Jitters: A Chronicle of the Asian Crisis, April 1999
 4

Chart 1:
 5

Chart 2:

c) Causes of the crisis

There are two common interpretations of what caused the financial crisis that struck a
number of East Asian economies in 1997. One emphasizes internal problems in the
countries affected, mainly fragility in their financial sectors resulting from lax
government regulation and over reliance on government guarantees. The other argues
that fragility in the international capital markets is the problem: in this interpretation,
a small liquidity problem in one country (Thailand) triggered a financial panic that
spread to encompass a number of countries in the region and imposed enormous
economic costs on them all.
Capital inflows to the region rose from an average of 1.4 percent of GDP during the
1986–90 period to 6.7 percent during the years from 1990 to 1996, with Thailand’s
inflow rising to 10.3 percent (Table 1). Any shock that induced a large drop in
capital inflows had the potential to create serious financial problems for the
countries in the region.
So it happened: international capital flows changed dramatically around the time of
the crash. According to the Institute for International Finance2, private capital
flows for the five hardest-hit countries reversed direction, going from an inflow of
$93 billion in 1996 to an outflow of $12 billion in the crisis year of 1997, for a

2
IMF World Economic Outlook (1998), Chapter II, The crisis in emerging markets- and other issues in
current conjuncture, October 1998 International Monetary Fund
 6

total swing of $105 billion. About three-fourths of the swing ($77 billion) was
accounted for by commercial bank lending. Between 1996 and 1997,Thailand
experienced a sudden reversal of private capital inflows, which amounted to about
20% of GDP. The other countries faced a similar fate. Net financial inflows to
Indonesia, Korea, Malaysia, the Philippines, and Thailand were $92.9 billion in
1996 and -$12.1 billion in 1997. The swing of $105 billion dollars of capital
inflows (from $93 billion inflows to 12 billion outflows) amounted to 11% of the
pre-crisis dollar GDP of the five Asian countries. It is no wonder that this large-
scale shift in financial flows provoked deep economic contractions and financial
embarrassment (Chart 3).

Table 1:

Before their sudden reversal, large inflows of capital left various economic
impacts on the Asian countries concerned. First, they contributed to appreciating real
exchange rates. Despite the enlarging current account deficits, steady inflow of capital
 7

delayed currency devaluation in many countries and resulted in the loss of

international competitiveness. Second, large capital inflows expanded domestic bank
lending and increased the vulnerability of the financial system to a reversal of capital
inflows. A significant proportion of bank lending was used for purchasing real estate,
property and equities and consequently generated asset market bubbles. The bubbles
simultaneously increased the vulnerability of financial institutions to the decline in
domestic real estate and equity markets.

Chart 3:

The moral hazard problem is another cause of the crisis. Depositors flocked to
financial institutions that pay higher interest rates without paying much attention to
their credit risks. Instead of making investment or loan decisions based on return and
risk trade-off, financial intermediaries as well as business enterprises ventured upon
whatever projects that could pay higher returns in the event of success. Owners and
managers believed that the government would bail them out in case of failure.
 8

The problem of moral hazard and excess investment intensified with economic
growth and financial market opening in Asia. As the size of the economy grew, it
became increasingly difficult for the government to monitor and supervise financial
institutions.
Another contributing factor is the sharp appreciation of the dollar in foreign exchange
markets. Between early 1995 and early 1997, just before the Asian financial crisis
broke out, the dollar rose considerably. Versus the Japanese yen the dollar’s rise was
close to 50 percent (Chart 4). Changes in the value of the dollar had a direct effect on
the economies at the center of the Asian financial crisis because all those countries
were tying their own exchange rates closely to the dollar in the years before the crisis.
When the dollar appreciated, the currencies of the crisis countries rose along with it.
Such appreciation had the potential to induce a significant slowdown in the important
export sectors of the crisis countries, and slowdowns in export growth often trigger
exchange rate and financial crises. This shock was probably a significant factor in
precipitating the crisis.

The indirect effects of dollar appreciation were quite important. An important aspect
of the East Asian economic miracle was rapid growth of exports. Thailand, Korea,
and Malaysia all showed dramatic slowdowns in growth of exports to the United
States in 19963, whereas all three countries had strong growth in exports during the
previous two years. Korea again showed the most dramatic reversal: its exports to
the United States rose an average of nearly 30 percent per year during 1994–95 but
fell more than 6 percent in 1996(Table 2).

Chart 4:

3
Whitt Joseph (1998), The Role of External Shocks in the Asian Financial Crisis, Working Paper,
Atlanta Fed’s Research Department, 1998
 9

Table 2:

An alternative explanation focuses on weaknesses in the international financial

system. From this perspective, the problems in Asia were a case of financial panic and
contagion by international lenders who suddenly refused to extend short-term loans to
solvent borrowers. With international short-term debts exceeding short-term assets
and no effective international lender of last resort, the loss of creditor confidence
resulted in a financial crash in much of the region, with severe consequences for the
economies involved.
The latter places primary responsibility for the crisis on the structural weakness of
Asian capitalism, especially its financial system. Inexperience and inefficiency among
financial institutions in the pricing and risk management, inadequate regulation and
supervision of financial institutions, poor corporate governance, all had contributed to
imprudent lending and inefficient investment spending which in turn weakened the
stability of the financial system.
Trade linkages moreover, provide a channel for contagion and they tend to be
strong within geographic regions such as East Asia. Because trade volumes tend to
decline with distance, a devaluing country’s closest neighbors are likely to suffer
the most and therefore are most likely to be hit by a speculative attack.
Accordingly, contagion is likely to show a regional pattern (See Appendix).
 10

On the eve of each crisis, when their foreign currency reserves were quickly drying
out, the Indonesian, Korean, and Thai governments did not recognize the seriousness
of their problems and wasted a substantial part of foreign reserves in their futile
foreign exchange market intervention. Such intervention swiftly depleted the official
reserves, which in turn started a vicious circle of impairing foreign investor
confidence and accelerating capital outflows. To restore foreign investor confidence,
the Thai and Korean governments pledged they would guarantee foreign liabilities of
domestic financial institutions and bail out troubled private banks. This was a crucial
policy mistake that paved the way for a private banking crisis and then into a
sovereign crisis.
Weaknesses in bank and corporate governance and lack of market discipline allowed
excessive risk taking, as prudential regulations were weak or poorly enforced. Close
relationships between governments, financial institutions, and borrowers worsened the
problems, particularly in Indonesia and Korea. More generally, weak accounting
standards, especially for loan valuation, and disclosure practices helped hide the
growing weaknesses from policymakers, supervisors, market participants, and
international financial institutions. In addition, inadequacies in assessing country risk
on the part of the lenders contributed to the crisis.

d) Implications of the crisis for the restructuring of the International Monetary

System

The crisis raises a number of important issues for the international financial system,
many of which are related to the development of a new international financial
architecture. The unfolding of the crisis revealed the inherent difficulty of stopping a
crisis once it has started.
Therefore, the design of the IMF program for the Asian crisis focused on fixing the
structural weakness in the financial sector. According to the IMF, the first priority
should be to restore confidence in the currency4. Only after the exchange market
becomes stabilized can necessary foreign funds for a successful structural reform be
secured. The IMF policy, therefore, which simultaneously pursues structural reform
and foreign exchange market stabilization, encourages monetary and fiscal policies
consistent with the choice of the exchange rate system.
Many policy prescriptions have been suggested for strengthening the financial system:
Broad-based reforms are under way to strengthen the institutional, administrative, and
legal frameworks in the crisis countries, based on international best practices,
codes, core principles, and standards. The crisis has shown the need to tailor
policies so that inevitable economic downturns become easier to deal with.

International efforts have been undertaken to reduce the likelihood and intensity of
future crises. Initiatives include work on the international financial architecture, the
Financial Stability Forum, and financial sector stability assessments. The Basle
Committee on Banking Supervision has formulated improvements to regulation

4
IMF International Capital Markets (1998), Chapter III, Emerging Markets in the New International
Financial System: Implications of the Asian Crisis, September 1998 International Monetary Fund
 11

and supervision of international lenders to address weaknesses that contributed to

the Asian crisis.

These improvements include strategies for dealing with the financial sector crisis,
which have the following components: stabilization of the financial system;
changes in the institutional framework to deal effectively with this and other
potential crises; resolution of nonviable financial institutions; strengthening of
viable financial institutions; management of nonperforming assets; and
restructuring of the corporate sector.

While the Asian crisis showed that the IMF would need to play a central role in
assisting the authorities in the management of the initial crisis and in the design
of the overall restructuring strategy, it also demonstrated the need for close
cooperation with other multilateral agencies, particularly the World Bank.
Cooperation with the World Bank was close from the beginning in all countries.
The World Bank provided expertise, and financing, to assist the authorities in
program implementation and institution building, increasing its role in the crisis
countries over time. In all crisis countries, the staffs of the IMF and World Bank
have cooperated closely from the early stages, taking into account each other’s
views in the program discussions with the authorities. In addition, World Bank
staff took the lead in the area of corporate restructuring and nonbank financial
institutions.

Strengthened international surveillance with closer monitoring of the financial sector

and a focus on international standards is under way to help alert policymakers to
upcoming problems. Such surveillance also incorporates a regional perspective to
provide warnings of impending regional contagion of the kind that spread the Asian
crisis.

e) Implications of the crisis for international financial regulation

Prudential regulation and supervision have been strengthened to foster better bank
governance and stronger market discipline. In all the countries, domestic standards are
being brought closer to international best practices, including areas such as foreign
exchange exposure, liquidity management, connected lending, loan concentration,
loan provisioning, data disclosure, and qualifications for owners and managers.

All countries have made efforts to upgrade their supervisory capacity and strengthen
the powers of supervisors. Supervisory reporting by banks has been much improved.
Moreover, supervisors can now demand additional loan-loss provisioning from banks,
corrective actions when problems are detected, and more support from banks’ external
auditors.

The definitions of capital have been improved and, in some countries, the absolute
minimum levels of capital have been increased. Banks were given time to comply
with these new regulations, according to specific timetables.

Several other key prudential regulations are being improved. These include foreign
exchange exposure limits in all countries, liquidity management rules in Indonesia,
Korea, and Malaysia, connected lending regulations in Indonesia and Korea and
 12

single borrower and group exposure limits in Korea and Malaysia. Most countries
have taken measures to improve transparency and disclosure, as well as the quality
of data disclosed. Quality of data has been improved by new loan classification,
provisioning, and income recognition rules and by extensive involvement of onsite
examiners and international auditors and analysts to support banks’ recapitalization
efforts, as mentioned above. This is expected to enhance governance and market
discipline over time.

Another issue is that of capital controls. Here, there are three key aspects: one is the
sequencing of capital account liberalization, where the crisis has highlighted the
pitfalls of liberalizing short-term flows while leaving restrictions on longer-term
flows, as well as the need to keep the pace of capital account liberalization in line
with the strengthening of the domestic financial system. A second relates to the
possible merits of taxes to discourage short-term capital inflows.

All the above steps support the long-term objective of the IMF’s response to the Asian
financial crisis, which is both to enable the affected Asian economies to emerge more
strongly to resume development and to help strengthen the international monetary
system as well as improve international financial regulation to meet the challenges of
the 21st century.
ORMS
 13

Appendix:

High-Frequency Contagion in the Exchange and Equity Markets

One of the factors complicating stabilization efforts during the East Asian crisis was the
contagion across countries. Such contagion effects arise because of trade and financial
linkages, or because events in one country change perceptions about prospects in others, or
simply because of herd behavior on the part of investors:
5
“While there are various measures of contagion, perhaps the simplest and most robust is the
correlation of exchange rate (or stock market price) movements across countries. These
correlations rose significantly in the latter half of 1997 and, while falling somewhat more
recently, remain positive and significant. Using a sample consisting of Indonesia, Korea,
Malaysia, the Philippines, and Thailand, the accompanying table reports a panel regression
of daily exchange rate (or stock market price) movement in one country on the average ex-
change rate (stock market price) movement in the four other countries (denoted the
“contagion” variable).1
According to the estimates, a 1 percent average depreciation in the four other countries is
associated with a 0.38 percent depreciation in the country’s own exchange rate.2 Indeed,
there is Granger causality from the contagion variable to changes in the country’s own
exchange rate— that is, the contagion variable helps predict movements in that country’s
exchange rate even when past movements in the same country’s exchange rate are taken
into account. A 1 percent contagion depreciation is associated with a 0.31 depreciation on
the following day, controlling for lagged changes in the country’s own exchange rate. More
recently, the contagion effect has diminished in magnitude, while remaining positive and
highly statistically significant. Finally, it is worth noting that contagion effects are discernible
not only at very high frequencies but also with monthly data, and are robust to the inclusion
of the country’s interest rate (either in levels or in first differences).
The results for stock market prices are broadly similar. Estimating the regression over the
period July 1997 to June 1998 shows that a 1 percent decline in the average stock prices
of the four other countries is associated with a 0.64 percent decline in the country’s own
stock price. There is, however, some evidence of this “contagion” effect as far back as
1996 (albeit of smaller magnitude). As with exchange rate movements, the contagion
variable Granger causes subsequent movements in stock market prices.
1 Also included in the regression, but not reported, are four lags of the dependent variable
and the dollar-yen exchange rate.
2 It is also noteworthy that the significance of the contagion variable increases in the crisis
period (interacting the contagion variable with a dummy variable for the period July 1997–
May 1998 yields a coefficient of 0.76, t-statistic 3.56**), although this may also reflect the
greater flexibility of exchange rates in the crisis period than before.”

5
Phillips Steven, Lane Timothy et al. (1999), IMF supported programs in Indonesia, Korea and
Thailand: An Assessment, IMF Occasional Paper 178
 14

Regression Results:

Source: IMF Occasional Paper no.178

 15

REFERENCES TO THE LITERATURE:

Berg Andrew and Pattillo Catherine (1999), Are Currency Crises Predictable? A test,
IMF Staff Papers Vol.46, No.2 (June 1999)

Brownbridge Martin and Kirkpatrick Colin (1999), Financial Sector Regulation: The
Lessons of the Asian Crisis, Development Policy Review Vol.17 (1999) pp.243-266

Camdessus Michael (1997), The Asian Financial crisis and the opportunities of
globalisation, speech by Michael Camdessus, Managing Director of the International
Monetary Fund at the second Committee of the United Nations General Assembly,
New York, October 31,1997,source:IMF web page

Crafts Nicholas (1999), East Asian Growth before and after the Crisis, IMF Staff
Papers, Vol.46 No.2 (June 1999), 1999 International Monetary Fund

Crafts Nicholas, London School of Economics (1999), Implications of financial crisis

for East Asian Trend Growth, Oxford Review of Economic Policy, Vol. 15,No. 3

Enoch Charles et al. (1999), Financial Sector Crisis and Restructuring: Lessons from
Asia, IMF Occasional Paper 188

Fabella Raul (1999), The East Asian Model and the Currency Crisis: Credit Policy
and Mundell-Fleming Flows, the Manchester School Vol. 67 No. 5, Special Issue
1999,1463-6786 475-495

Goldstein.M, (1998), The Asian financial crisis: Causes, Cures and Systematic
Implications, Institute of International Economics

Higgott Richard (1998), The Politics of Economic Crisis in East Asia: Some Longer
Term Implications, CSGR Working Paper No.02/98, March 1998

IMF International Capital Markets (1998), Chapter III, Emerging Markets in the New
International Financial System: Implications of the Asian Crisis, September 1998
International Monetary Fund

IMF World Economic Outlook (1998), Chapter II, The crisis in emerging markets-
and other issues in current conjuncture, October 1998 International Monetary Fund
 16

IMF World Economic Outlook (1998), Chapter III, The Asian Crisis and the
Region’s Long-Term Growth Performance, October 1998 International Monetary
Fund

IMF World Economic Outlook (1999), Chapter III, International Financial

Contagion, May 1999 International Monetary Fund

Kaminsky Graciela and Schmuckler Sergio (1999), What Triggers Market Jitters: A
Chronicle of the Asian Crisis, Board of Governors of the Federal Reserve System,
International Finance Discussion Papers, Number 634, April 1999

Johnson A. Robert (1997), What Asia’s Financial Crisis Portends, December 29

1997,source:IMF web page

Lane Timothy (1999), The Asian Financial Crisis: What have we learned?, Finance
and Development, a quarterly magazine of the IMF, September 1999,Volume
36,Number 3

Lee Wha-Yong and Rhee Changyong (1998), Social Impacts of the Asian Crisis:
Policy Challenges and Lessons, Korea University and Seoul National University,
November 1998(Working Paper)

Lim Joseph (1999), The Macroeconomics of the East Asian Crisis and the
Implications of the Crisis for Macroeconomic Theory, the Manchester School Vol.67
No.5, Special Issue 1999,1463-6786 428-459

Nixson Frederick and Walters Bernard (1999), The Asian Crisis: Causes and
Consequences, the Manchester School Vol.67 No.5, Special Issue 1999,1463-6786
496-523

Phillips Steven, Lane Timothy et al. (1999), IMF supported programs in Indonesia,
Korea and Thailand: An Assessment, IMF Occasional Paper 178

Radelet S. and Sachs, J.D., (1998) The East Asian Financial Crisis: Diagnosis,
Remedies, Prospects, Brookings Papers for Economic Activity, No. 1

Saito Kunio (1998), Seminar on ASEAN Financial Policy and Macroeconomic

Management: The Asian Financial Crisis and the IMF, March 24 1998, source: IMF
web page

Whitt Joseph (1998), The Role of External Shocks in the Asian Financial Crisis,
Working Paper, Atlanta Fed’s Research Department, 1998