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Causes behind the deepening of the Asian Crisis

Both the IMF and the World Bank, in the period preceding the Asian Crisis, defended what Joseph Stiglitz referred to as “market fundamentalism”. This means that they believed that free markets are the best possible solution to solve economic issues and so, decided to remove barriers that do not allow the unrestricted flow of capital in and out of the countries. However, it is necessary to take into consideration, that in order for a market liberalization to work, the countries need to have well-established institutions and possess enough economic information, which is not the case when we are talking about developing countries.

Additionally, Asian countries faced a major development, due to a large increase of their exports; this coupled with the alleviated conditions of the “market fundamentalism” led to massive capital inflows.

Usually, capital inflows driven by “pull” factors (intrinsic to the country receiving the capital) are not a matter of concern, but in this case were in the origin of the Asian Crisis.

The problem with massive capital inflows is what comes afterwards, when something shakes the credibility of the countries and provokes a substantial retrieval of the money. In this case, Asia credibility was shaken due to a devaluation of the Thai baht.

In order to mitigate the effects of the capital outflows that followed, the IMF promptly intervened by providing loans to the countries in need, however, with certain conditions:  countries needed to decrease government expenditure, increase interest rate and reduce imports. These measures usually apply to economies with problems concerning debt, inflation or Current Account deficits, which was not the case of the Asian countries.

By doing so, the IMF only aggravated the crisis, as it acted like Asia was facing a Current Account Crisis instead of a Capital Market Crisis.

In the reduction of the imports, the IMF led to a similar “impoverishment” of other regions, as a decrease in the imports is conversely accompanied by a decrease in the exports of the other countries. Moreover, by increasing the interest rates to astronomical levels, it led to bankruptcy of firms (who were not able to pay for their debts) and also of financial institutions (who never recovered their money). The bankruptcy of financial institutions occurs due to a coordination failure, because it would be preferable for individual investors to withhold liquidity from Asian countries, however, if it were possible to induce investors to provide said liquidity, everyone would be better off. A way to overcome this failure would be to have a single large investor to provide the liquidity in order to allow financial institutions not to bankrupt.

Furthermore, not only was the Asian Crisis triggered by capital outflows, but also due to a collapse of the value of collateral, which aggravated even more the liquidity crisis.

The existence of imperfections in the credit market can intensify economic disturbances, as was already stated above, firms’ credibility is shaken, so banks need to demand collateral in order to transfer their risk to the borrower.

The problem is, in recessions, the value of collateral tends to decrease, due to the fact that both people and banks sell their assets in order to obtain liquidity, which, conversely, leads to a decrease in the price of these assets and, hence, a decrease in the value of the collateral. This reduction of the value of collateral will lead the bank to cut credit.

In Thailand, this occurred with the burst of the land price bubble. High leverage-firms collapsed because the size of the loans depends on the value of the collateral in form of land. The reduction of the value of collateral created by the bursting of the bubble, means that the loans are no longer fully collaterised. Therefore, the banks reduce the loan limits. In order to repay the loans, borrowers sell land, leading to a reduction of the land prices and consequently to a bankrupt. These credit constraints create a vicious downward spiral in asset prices, leading to financial collapses.

Moreover, another important aspect that led to this crisis was the fact that Thailand Banks lent in foreign currency, so people needed to repay their loans in foreign currency. With the devaluation of the baht, this repayment became much more expensive that it should have, which deepened even more the liquidity crisis.

To sum up, first of all, after analyzing the policies implemented by the IMF, one can say that they were not appropriate to the crisis in question. Moreover, the principle of financial accelerator (decrease in value of collateral) was also a major trigger of the deepening of the financial Asian Crisis.

#637 and #672

Author: studentnovasbe

Master student in Nova Sbe

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