The Asian Financial Crisis of 1997

Prior to 1997, many economists referred to an Asian “economic miracle”. Countries such as Japan, South Korea, and Singapore had experienced extraordinary economic growth for several decades (although by 1990 growth had slowed in Japan). In 1997 an economic crisis hit Asia that led to a severe recession in several countries.

The crisis began in Thailand, Indonesia, and Malaysia. Although these countries had not experienced the same success as Japan or South Korea, they had been growing rapidly prior to the crisis. Their economies shared several characteristics:

1. Central to their economic growth was the exporting of labor-intensive manufacturing goods. This pattern had been very successful for Japan and South Korea.

2. To ensure a high price for their exports, and to encourage economic stability, these governments had pursued a policy of a fixed exchange rate pegged against the dollar.

3. These governments had managed to keep exchange rates very stable for several years.

4. Encouraged by high rates of return and an apparently stable currency, foreign banks and investors had issued a great deal of debt to Asian firms.

5. These loans allowed governments to finance significant budget deficits.

6. To defend their fixed exchange rate, these governments had to expend reserves of foreign currency to make up for the difference between supply and demand in exchange rate markets.

To maintain a fixed exchange rate, the government must constantly spend some of its reserves of foreign currency. Eventually, it is inevitable that the government will run out of reserves and will be unable to make up the difference between supply and demand. At this point, the government must abandon the fixed exchange rate and the currency will depreciate. This is known as a balance of payments crisis.
Balance of payments crises had been common before 1997. Latin America had suffered several and Europe had been hit in 1992. Although they produced significant macroeconomic effects, the results had never been as catastrophic as they would be in Asia.

It is not generally the case that reserves will dwindle down to zero before there is currency devaluation. Suppose that investors notice that the government is running low on reserves and that a devaluation will occur shortly. If investors hold on to the currency, they will lose out when it depreciates. They therefore will instigate a run on the currency before reserves reach zero. The government may not have enough reserves on hand to defend the fixed exchange rate and they will have to let the currency depreciate.

In June 1997, several large investors began to sell large quantities of Asian currencies. The governments held enough reserves to accommodate these sell-offs without creating a balance of payments crisis.

Many economists believe that other investors were not acting rationally. Instead of evaluating the actual strength of their investments in the Asian economies, the adopted a “herd mentality” and followed the lead of the original investors who disinvested in the Asian economies. The governments did not hold enough reserves to accommodate this sell off and several currencies collapsed.

Thailand was the fist country hit. It was forced to abandon it peg on 7/2/97. For the remainder of 1997, the baht fell by 33%.

Malaysia abandoned its fixed exchange rate on 8/17/97. For the remainder of 1997, the ringgit fell by 23.3%.

Indonesia abandoned its fixed exchange rate on 8/14/97. For the remainder of 1997, the rupiah fell by 40.4%.