On July 2, 1997, Thailand devalued its currency against the US dollar. This event, following months of speculative pressure that substantially depleted Thailand’s official foreign exchange reserves, marked the start of a deep financial crisis across much of East Asia.
In the following months, Thailand’s currency, stock and property markets weakened further as its difficulties escalated into a double balance of payments crisis and a banking crisis. Malaysia, the Philippines and Indonesia also allowed their currencies to weaken significantly in the face of market pressures, with Indonesia gradually falling into a multifaceted financial and political crisis. Hong Kong has faced several large but unsuccessful speculative attacks on its currency’s peg to the dollar, the first of which triggered short-term sell-offs in stock markets around the world. And serious problems with the balance of payments in South Korea have put the country on the brink of default.
Across East Asia, capital inflows slowed or reversed, and growth slowed sharply. Banks have come under intense pressure, investment rates have fallen and some Asian countries have entered deep recessions, resulting in significant spillovers for trading partners around the world.
The events that have come to be known as the Asian financial crisis have generally taken market participants and policy makers by surprise.
While some vulnerabilities were well known before the crisis hit, especially in Thailand, these countries’ economies were also considered to have many strengths. Indeed, the hardest-hit economies were among the most successful in the world in the pre-crisis decade. Business-friendly policies and prudent fiscal and monetary management have led to strong savings and investment, supporting GDP growth rates above 5 percent and often close to 10 percent.
However, as the crisis unfolded, it became clear that these countries’ high growth rates masked important vulnerabilities. In particular, years of rapid growth in domestic credit and inadequate supervisory oversight have led to a significant increase in financial leverage and bad loans.
The overheating of the domestic economy and real estate markets exacerbated the risks and led to increased dependence on foreign savings, which was reflected in the widening current account deficit and the buildup of external debt.
Large foreign borrowing, often with short maturities, also exposed corporations and banks to significant foreign exchange and financing risks, risks that were masked by longstanding currency pegs. When the pegs proved unsustainable, firms faced a sharp increase in the value of their foreign debt in local currency, leading many into distress and even insolvency.
The unfolding crisis in Thailand has shown how problems in the banking sector can lead to an outflow of foreign investors, setting off a spiral of depreciation, recession and increased weakness in the banking sector. The result was contagion as foreign lenders abandoned other countries in the region that were seen as equally vulnerable.
The deteriorating economic and financial situation in Japan also played a role, as Japanese banks, formerly an important source of credit, have withdrawn from lending activities in the region. In the face of these pressures, foreign exchange interventions often proved counterproductive, as some countries depleted much of their official reserves and were subject to even greater subsequent depreciation.
In response to the spreading crisis, the international community has mobilized massive loans totaling $118 billion to Thailand, Indonesia and South Korea, and taken other actions to stabilize the hardest hit countries. Financial support came from the International Monetary Fund, the World Bank, the Asian Development Bank and the governments of the Asia-Pacific region, Europe and the United States. The main strategy was to help crisis-hit countries rebuild official reserves and buy time for policy adjustments to restore confidence and stabilize economies, and to minimize long-term disruptions in countries’ relationships with their external creditors.
To address the structural weaknesses exposed by the crisis, aid depended on significant domestic policy reforms. The set of policies varied by country, but generally included measures to reduce deleveraging, clean up and strengthen weak financial systems, and make their economies more competitive and resilient.
From a macroeconomic standpoint, countries have raised interest rates to help stabilize currencies and tightened fiscal policy to speed up external adjustment and cover the costs of bank cleanups. However, over time, as markets began to stabilize, the macroeconomic policy mix changed to include some loosening of fiscal and interest rate policies to support growth.
The Federal Reserve has played an active role in informing and supporting policy actions in the United States and around the world. Behind the scenes, the Federal Reserve provided timely analysis of key adjustment challenges and closely monitored the risks the crisis posed to US banks and the funding status and profiles of Asian bank branches in the United States, while coordinating policy with other banking supervisors in the US. US and internationally.
The Fed also acted as an agent for the US Treasury, including helping arrange a bridge loan for Thailand in the early stages of the crisis.
Perhaps most notably, the Federal Reserve has played a catalytic role in the official sector’s efforts to encourage banks to act in their collective self-interest, helping South Korea avoid a disorderly default. Following a December 24, 1997 meeting hosted by the Federal Reserve Bank of New York, US banks with the greatest risk to South Korean banks voluntarily committed to rolling over their short-term loans and working with the South Korean authorities to restructure them. in medium-term loans. Similar meetings and other forms of outreach have taken place in other G-10 countries. In the months that followed, the Federal Reserve and other central banks watched the banks cooperate with their rollover commitments until the completion of the restructuring in April 1998.
A combination of strong policy action by affected countries and external support from the international community ultimately contained the crisis and paved the way for a sustainable recovery to follow.
For the United States, the adverse direct impact of the Asian crisis on trade proved manageable and was partly offset by some other, more positive spillovers, including reduced inflationary pressures (due to cheaper Asian imports and lower global commodity prices) and lower yields on bonds (due to the flight into dollar assets).
The negative consequences for some other countries were more significant. In particular, a number of emerging market economies in Latin America and Eastern Europe, including Brazil and Russia, faced significant balance of payments pressures in 1998, reflecting spillover effects from the Asian crisis as well as domestic vulnerabilities, some of which were quite severe. different from those that underlie the Asian crisis.