How Asia shrugged off its economic crisis

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Ten years ago, on July 2nd 1997, Thailand's central bank floated the baht after failing to protect the currency from speculative attack. The move triggered a financial and economic collapse that quickly spread to other economies in the region, causing GDP growth rates to contract precipitously, bankrupting companies that had overexposed themselves to foreign-currency risk, and ultimately necessitating costly and politically humiliating IMF-led bailouts in the worst-affected countries. Thus began the Asian financial crisis of 1997-98. Its effects, and governments' subsequent responses to it, have defined much of the region's economic policies and direction in the past decade. What has been learnt, and how has the region changed in the intervening period?
The financial crisis can be described as having been a "perfect storm": a confluence of various conditions that not only created financial and economic turbulence but also greatly magnified its impact. Among the key conditions were the presence of fixed or semi-fixed exchange rates in countries such as Thailand, Indonesia and South Korea; large current-account deficits that created downward pressure on those countries' currencies, encouraging speculative attacks; and high domestic interest rates that had encouraged companies to borrow heavily offshore (at lower interest rates) in order to fund aggressive and poorly supervised investment. Weak oversight of domestic lending and, in some cases, rising public debt also contributed to the crisis and made its effects worse once the problems had begun.
If factors such as exchange-rate policies had helped to precipitate the financial crisis, above all it was excessive and poorly supervised foreign borrowing that made it so disastrous. As it became too expensive to fend off speculators, currencies were forced to float. This resulted in large falls in the baht, the won and the rupiah against the US dollar. For instance, from an average of Rp2,342 to the US dollar in 1996, the rupiah fell to an average of Rp10,014 in 1998. As a result, companies that had received large unhedged foreign-currency loans now faced impossibly high debt repayments in domestic-currency terms. The panicked capital flight that ensued only exacerbated the currency depreciation, leaving indebted companies in even direr straits. The workout of the bad debts and disposal of the distressed assets created by the crisis was one of the major tasks for policymakers for several years thereafter.
The situation now could not be more different. Most Asian economies now enjoy sizeable current-account surpluses and have built up extensive foreign-exchange reserves with which, in theory, they could protect their currencies from speculative attack in future. (Indeed, it is an enduring complaint of economists these days that Asian countries have gone too far in the opposite direction, having built up far greater levels of reserves than they need.) Non-performing loans (NPLs) in the banking sector have fallen, and extensive financial reforms have taken place. As a result, not only are the region's fundamentals no longer conducive to an exact repeat of the 1997-98 crisis, but regulatory controls have also, by and large, improved substantially. Thus, even were some of the conditions that existed in 1996 and early 1997 to reappear in the region, it would no longer be so easy for companies to get themselves into as much trouble as they did then.
This does not mean, of course, that the region no longer faces substantial economic risks. New imbalances and problems have emerged in the past few years, in part relating to the massive US current-account deficit and Asian central banks' large holdings of US Treasuries. The following paragraphs explore the specific changes that individual "crisis" economies in Asia have undergone in the past decade, and the new challenges and risks they face.
THAILAND
A decade on from the financial crisis of 1997, Thailand finds itself in the midst of another crisis, this time a political one. Although the economy has been suffering from a downturn in business confidence in the wake of the September 2006 military coup, Thailand's economic fundamentals are nevertheless generally strong. Indeed, rather than battling the markets to prop up the baht, the Bank of Thailand (BOT, the central bank) has been under pressure to weaken it. In order to do so, in late 2006 the BOT imposed controls on the inflow of capital. The baht now stands at a nine-year high of around Bt34.5:US$1 on the local market, and on the offshore market it has risen to Bt32.3US$1.
The country's external accounts are far healthier: the current account has been in surplus every year since 1997 except 2005; foreign-exchange reserves have soared to US$71bn, up from the 1997 low of US$26bn reached when the BOT gave up its costly efforts to keep the baht fixed to the dollar; and external debt levels have dropped sharply, with most of the private sector's short-term debt taking the form of trade credits rather than loans, a reversal from the pre-1997 situation.
The banking sector has also recovered well, with NPLs dropping to around 4-5% of total outstanding loans--a decade ago the ratio was close to 50%. A process of consolidation in the banking sector has also been under way since 2004, and regulatory standards and bank lending practices have improved markedly.
INDONESIA
Indonesia's external position is far more comfortable than it was before the Asian financial crisis. Its current account recorded an estimated surplus of 2.6% of GDP in 2006, compared with a deficit of 3% of GDP in 1996. Its foreign-exchange reserves now cover 5.2 months of imports, compared with 3.9 months before the crisis. External debt ratios have fallen dramatically. Furthermore, unlike before the crisis when the currency was pegged at an artificially high exchange rate, the exchange rate has been allowed to adjust with some freedom in recent years, meaning it is less vulnerable to speculative attack.
The caution created by the financial crisis has left the banking sector far more stable. The ratio of loans to assets has fallen considerably and borrowing in foreign currencies has been reduced, meaning there is less repayment risk associated with currency volatility.
But if Indonesia has successfully reduced macroeconomic and financial vulnerabilities, it has failed to convince investors that it has repaired the cracks in its business environment that the crisis exposed. Even as recently as 2006, real investment had not returned to its pre-crisis level. Corruption is still perceived to be rife despite a high-profile crackdown, legal uncertainty is still a concern, and bureaucracy remains problematic.
There are signs that this may be beginning to change. A new investment law shows that the government is becoming more intent on making it easier to conduct business in Indonesia, and investment figures for the past two quarters have been very encouraging. One of the biggest changes for the better in Indonesia since the 1997-98 crisis has been the shift to a more democratic political system. This offers hope that governance can improve further. If political stability is maintained, Indonesia could be about to experience an investment boom that finally breathes life into the economy again.
SOUTH KOREA
"The bigger they are, the harder they fall," is a maxim that aptly describes South Korea's experiences-and those of many of the chaebol, the country's industrial conglomerates-during the Asian financial crisis. South Korea was one of the countries worst hit by the crisis, and its IMF-led emergency bail-out programme cost around US$60bn.
To its credit, South Korea has also been one of the most diligent countries in implementing post-crisis economic and financial reforms, and it is now reaping the rewards of these efforts. The country's financial sector is one of the region's strongest, combining greater openness with better regulation. It is a measure of the improvement in prudential standards that the crisis among overextended credit-card lenders in 2003 had almost no contagious effect on the broader financial system.
In addition, South Korea's economy is now more transparent and flexible, interest rates are lower, and foreign reserves-which at the height of the crisis in December 1997 were down to US8.9$bn-have risen massively, to US$243bn as of end-March 2007. Indeed, South Korea is typical of post-crisis Asian economies in that it now faces considerable difficulty in preventing further accumulation of foreign reserves and keeping its currency from appreciating. This is a concern for exporters, particularly given the current weakness of the yen, as South Korean industrial exporters compete with Japan in numerous sectors.
Despite the progress on reforms that South Korea has made, unfinished business remains. This is particularly the case with regard to the labour market, which is still rigid and prone to disruptive unrest.
MALAYSIA
The crisis of 1997-98 had a profound effect on macroeconomic conditions in Malaysia. Having grown by an annual average of 9.6% in the five years preceding the crisis, the economy contracted by 7.4% in 1998. The shrinkage reflected a sharp retraction in investment spending, weak external demand and a huge drop in household spending. The government reacted with an unorthodox policy mix of pegging the currency against the US dollar, implementing exchange controls and adopting deficit financing to reflate domestic demand.
Since the crisis, Malaysia has made good progress in reforming its banking and financial system. Local banks have been consolidated, while gradual liberalisation has led to increased competition, especially from foreign banks. In recent years, the government has also progressively dismantled the exchange and other controls imposed during the crisis--including abandoning the ringgit peg to the US dollar in July 2005 in favour of a managed float, although offshore ringgit trading is still prohibited.
Today, Malaysia is in rude economic health, benefiting from relatively firm external demand for electronics and electrical products and strong domestic consumption. In 2006 the economy grew by 5.9%, slightly faster than the Association of South-East Asian Nations average of 5.8%. Major restructuring in the financial sector and the build-up of foreign-exchange reserves-to levels sufficient to finance more than eight months of retained imports-have left Malaysia better equipped to deal with financial emergencies.
However, other economic challenges remain. Malaysia needs to achieve further progress in corporate governance and transparency. It also needs to make concerted efforts to move up the value chain to compete successfully against China and other low-cost manufacturing economies. Moreover, diversification away from export-oriented industries to the services sector is essential if Malaysia is to achieve developed-nation status by 2020.
HONG KONG
Hong Kong's small and open economy is inherently vulnerable to events outside its control. As a result, despite not suffering from any of the imbalances that the other crisis-hit economies were showing on the eve of the Asian financial crisis, Hong Kong ended up being one of the worst hit by the turmoil. Real GDP contracted by 5.5% in 1998, and with the territory suffering from six consecutive years of deflation, nominal GDP in Hong Kong did not overtake its pre-crisis level until 2005. Growth in the first five years after the crisis continued to be volatile, with the economy suffering a deep downturn in 2001, after the collapse of the dotcom bubble in the US; the economy also wobbled again briefly in 2003, at the height of the SARS crisis.
However, the past three years have seen a return to sustained, strong economic growth, with real GDP growing by an average of 7.7% in the period 2004-06. The main reason for this strong recovery has been the fast-growing mainland Chinese economy. Booming trade with China has led to a big increase in Hong Kong's re-export trade, and has driven a massive expansion in Hong Kong's container port throughput, as well as air cargo traffic. Looser travel restrictions on Chinese tourists have also provided a significant boost to Hong Kong's hotel, restaurant and retail sectors. Finally, the listing of a number of major Chinese companies in the past two years, including three of China's "Big Four" state-owned banks, has given a significant boost to Hong Kong's important financial-services sector.
Although Hong Kong has recovered strongly from the Asian financial crisis, the openness of the economy means that Hong Kong's prospects will continue to be tied to events elsewhere. Although the territory's closer integration with the mainland economy may have made it less vulnerable to a slowdown in Asian growth, by the same token it has also made Hong Kong more vulnerable to a slowdown in Chinese growth.
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