South East Crisis 1997: Measures to Face the Crisis and

Government Policy to Solve the Crisis

Jorge Yeshayahu Gonzales-Lara

International Economic
 South East Crisis 1997: Measures to Face the Crisis
and Government Policy to Solve the Crisis
Jorge Yeshayahu Gonzales-Lara

Antecedents

In mid-1997, one of the deepest financial and economic crises in Asia broke out [Korea, Indonesia,

Japan, Malaysia and Thailand]. What appeared to be a regional crisis eventually became the first

crisis of globalization, due to the impact and magnitude of its effects on the global economy. The

Miracle of East Asia became the Asian financial nightmare.

The crisis began in July 1997, when speculators toppled the Thai baht. The currencies of Indonesia,

South Korea and Malaysia were also affected. The financial crises that broke out in Asia in mid-

1997 have lagged behind and the affected economies experienced a recovery, which was not

spontaneous, but the result of the stubborn application of economic policy measures by the affected

countries and financial support of the affected countries. Programs supported by the IMF for the

crisis in Korea, Indonesia and Thailand. The crisis began in Thailand with the financial collapse

of the Thai baht, caused by the decision of the Thai government to make the baht fluctuate,

reducing its parity with the US dollar, after exhaustive efforts to sustain it before a severe financial

expansion; that was partially forced by the real estate sector. Thailand had acquired a burden of

external debt that caused the country's effective bankruptcy even before the collapse of its

currency. The crisis expanded, most countries in Southeast Asia and Japan saw the collapse of

their currencies, the devaluation of the stock market and other assets and a precipitous drop in

private debt. As a result, devaluations of currencies in Malaysia, Indonesia and the Philippines

affected Taiwan, Hong Kong and South Korea. Four Asian tigers that appeared to be a regional

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crisis became the first crisis of globalization, due to the impact and magnitude of its effects on the

world economy.

The Foreign Debt ratios. Gross Domestic Product rose from a 100% rate to 167% in the four largest

economies in Southeast Asia in the period 1993-1996, and then shot up to over 180% during the

worst part of the crisis. In Korea, the ratio increased by 13-21% and then by 40%. Asia attracted

almost half of the total affluent capital to developing countries. (Crisis financiera asiática PP. 1)

Evolución del Tipo de Cambio y del Indice Bursátil de Países Asiáticos

entre el 1º julio de 1997 y el 29 de octubre de 1998

VARIACION DEL TIPO VARIACIONES DEL

PAISES DE
INDICE BURSATIL**
CAMBIO*
JAPON -1.46% -32.77%
PAISES COREA DEL SUR 49.15% -44.04%
EN MALASIA 44.16% -63.44%
CRISIS TAILANDIA 16.06% -48.16%
INDONESIA 180.77% -57.10%
CHINA -0.15% 3.77%
OTROS FILIPINAS 40.48% -36.21%
PAISES HONG KONG 0.07% -39.32%
ASIATICOS SINGAPUR 10.15% -39.20%
TAIWAN 16.05% -30.29%

In particular, Southeast Asian economies maintained high interest rates that attracted foreign

investors in search of high rates of return. As a result, the economies of the region received a large

influx of money and experienced a dramatic increase in active prices.

The crisis in Thailand is explained by the unsustainable policy. The exchange guarantee

encourages excessive external borrowing, particularly in the short term. Inadequate regulation and

supervision that allowed banks and other financial institutions to assume high exchange and credit

risks, which contributed to the deterioration of the economic situation. The crisis in Indonesia is

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deeper since the financial crisis led to a political crisis. The crisis in Indonesia is deeper since the

financial crisis leads to a political crisis. It is a country that is beginning the financial crisis in an

environment in which institutions are weakened by political uncertainty, fueled initially by the

deterioration of President Suharto's health; a devastating drought that impoverishes the rural

population and a society fractured by the resurgence of ethnic conflicts. In addition, Indonesia

suffers a significant decrease in its income due to the fall in oil prices.

Origins of South East Crisis 1997

The causes of the crisis in the countries of Southeast Asia can be divided into macroeconomic and

microeconomic. The macroeconomic origins are both internal and external. Among the external

causes, the most important is the contagion effect and the large short-term external debt by banks

and companies. Among the internal macroeconomic causes, the most important is the creation of

bubbles in asset prices (real estate and shares) which, together with poor regulation and supervision

of the financial system, contributed to excessive indebtedness and inadequate diversification of the

portfolio of banks. In addition to this, several countries in Asia suffered increasing political

instability that led to changes in government in Indonesia and Thailand during 1997 and in Japan

during 1998. In particular, in Indonesia the political and social situation has deteriorated

drastically, this being the main factor that explains the magnification of the financial crisis. This

instability had the effect of keeping interest rates at high levels, and of delaying the adoption of

measures to deal with the crisis. The microeconomic part can be divided into a financial

deregulation that was accompanied by inadequate supervision and regulation and in a bad internal

administration of the banks.

Measures to Face the Crisis

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Countries that operated under a predetermined exchange rate regime before the crisis were more

vulnerable to speculative attacks against their currency; this is the case of Korea, Indonesia and

Thailand. It should be noted that because this exchange regime commits the government to allocate

resources to maintain exchange rate parity, countries with this exchange regime have been forced

to apply with greater speed and firm support to the financial system.

The reasons are:

1. The predetermined exchange rate regime seems to have increased the vulnerability of

financial institutions by promoting greater external indebtedness without coverage.

2. The implicit responsibility that governments have when granting a foreign exchange

guarantee commits them to apply public resources for the resolution of the crisis and

eventual rescue of financial institutions.

It contrasts the management of the crisis that the countries that maintain a flexible exchange regime

carry out; as is the case of Japan and Malaysia. The governments of both countries have shown

greater resistance to committing public resources to support the financial sector. It seems that these

countries have delayed the implementation of measures that definitively solve the banking

problem. However, the delay in the government action could be explained by a lower urgency due

to a less severe problem, since the responsibility of the authorities in the gestation of the crisis is

less because they did not encourage greater external indebtedness through its exchange rate policy.

In September 1998, Malaysia reversed its flexible exchange rate policy and fixed the parity of its

currency at an exchange rate of 3.8 ringgits per dollar, while imposing capital controls. The main

argument for this policy reversal is to reduce the burden of private external debt payments and

isolate the country from the short-term movements of capital flows.

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The main measures of capital control are:

(1) The resources obtained from the sale of assets in ringgits may be converted into foreign

currency only after a year of keeping them in local currency.

(2) Transactions of assets denominated in ringgits (as shares) will only be done in the

authorized institutions.

(3) Imports and exports must be settled in foreign currency (to limit the extraterritorial use

of the ringgit).

(4) The sale of currency to travelers will be restricted.

(5) Malaysians are prohibited from acquiring foreign assets with a value greater than

10,000 ringgits.

In terms of interventions to financial institutions, Korea, Indonesia and Thailand have closed and

intervened to a greater number of entities and with greater speed than Japan and Malaysia. This is

because they face a crisis of greater depth that has deteriorated financial institutions to a greater

degree. Due to greater room for action and greater resistance to the use of public funds, the

governments of Japan and Malaysia have preferred that these troubled institutions merge with

healthy institutions rather than suspend or intervene and allow, on a temporary basis, the operation

of banks with low capitalization. In terms of fiscal policy, at the outbreak of the crisis, Korea and

Malaysia, which had a comfortable fiscal position, adopt an expansive fiscal policy. The policy

shift is made with the purpose of stimulating the growth of the economy and smoothing the

recessive impact of the crisis, distributing the costs over time. Additionally, Korea relaxes its

monetary policy. Indonesia and Thailand, on the other hand, adopt a contractionary fiscal policy

at the beginning, increasing the fiscal surplus; however, it is foreseeable that the Indonesian

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government will reverse this policy due to the deep depression and social instability it faces. Due

to the severity of the crisis, Thailand has already reversed its contractionary policies due to

expansive policies. Contrast Japan that has followed an erratic policy in the nineties. The fiscal

restriction implemented at the beginning of 1997 is probably one of the main factors in the outbreak

of the crisis in Asia. As a consequence of this increase in taxes and weak private demand, Japan's

GDP fell by 2% instead of the 4% increase predicted by the IMF. This serious forecast error of 6

percentage points sharply reduced the demand for products from other Asian economies and

contributed to the reduction in capital flows to these economies.

Fiscal and Monetary Policy Adopted since the Crisis of 1997

Indonesia is a case in which the fiscal and monetary policy is contracted at the outbreak of

the crisis, of having a fiscal balance in 1996, and in 1997 a fiscal surplus of 2% of the GDP

was reached, with the fall of the GDP during the year, while the funding rate reached a

level of 81% at the beginning of the crisis. Thailand initially conducted a restrictive

monetary policy, the funding rate went from 10% in mid-1997 to levels of 25% at the

beginning of 1998. However, the severity of the crisis has caused the authorities to relax

their monetary policy by reducing this rate of funding at a level of 6% in October 1998.

Additionally, it has waived its commitment to conduct a contractionary fiscal policy and

has allowed the fiscal deficit to increase to a level of 3% of GDP (plus 1.5% - 2.0% for the

payment of interest on the bank rescue). It contrasts the fiscal policy of Korea, since in

order to smooth the process of adjustment, the authorities try to distribute the tax burden

in several periods; a fiscal deficit of 1.2% of GDP is projected for 1998 compared to a

balanced fiscal situation in 1997. Additionally, the Central Bank lowers the discount rate

from 5.0% to 3.0% in order to boost the granting of credit. Malaysia, as of January 1998,

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 conducts a restrictive monetary policy; The interbank interest rate increased from 8% at

the end of 1997 to 12% in March 1998. At the same time, the Central Bank has provided

liquidity to the financial system by reducing the reserve requirements of commercial banks

from 13.5% to 10% in February of 1998, and subsequently to 8% in July. On the other

hand, the authorities have adopted an expansive fiscal policy; the government balance went

from a surplus of 2.6% of GDP in 1997 to a 0.5% projected for 1998. In contrast, Japan

has followed an expansive monetary policy; since 1991, the Central Bank has gradually

reduced the discount rate from a level of 6% to its current level, representing a historical

minimum of only 0.25%. In contrast to monetary policy, during the 1990s the management

of fiscal policy has been erratic. During 1995 until the beginning of 1997, the fiscal policy

adopted was strongly expansionary. The fiscal stimuli in terms of higher spending and

lower taxes were of the order of 3% of GDP. This relaxation complemented monetary

policy, causing growth of more than 3% of GDP. This situation was reversed in April 1997,

when to reduce the deficit the government increased the consumption tax from 3% to 5%

and eliminated the temporary reduction to income tax. This policy had a severe effect on

the private sector and economic activity. During 1998, an expansive fiscal policy was again

adopted.

The response to the severity of the Asian crisis, international financial organizations and some

developed countries granted unprecedented assistance packages to try to contain the crisis in Asia.

Substantial credits from the International Monetary Fund were complemented with assistance from

the World Bank, the Asian Development Bank and some industrialized countries. Countries that

maintained a semi-fixed exchange rate regime (Korea, Indonesia and Thailand) required

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international support to meet their commitments abroad. In August 1997, Thailand obtained an

emergency international aid package for 17.1 billion dollars.

Intervention to Financial Institutions

In Japan, from December 1994 to November 1996, 13 financial institutions were merged,

in 7 of which the Central Bank of Japan financially supported the operation. However, the

bankruptcies in November 1997 of the Hokkaido Bank and Yamaichi Securities, register

disparities between the capital reported a few months before and the real capital for more

than 500 thousand and 260 billion yen respectively. These banks will be subject to the

bridge bank scheme explained in the annex, Table III of Japan. Korea attacked the

insolvency problem with great determination. In December 1997, 14 commercial banks

closed (these banks do not accept deposits from natural persons). This situation caused the

withdrawal of deposits from the banking system to accelerate and the banks to reduce the

credit granted, canceling even previously authorized lines of credit. In February 1998, the

operations of another merchant bank were suspended and an intervention was made to two

of the main commercial banks (Bank First of Korea and Bank of Seoul), which was

scheduled to be reprivatized in November 1998. In Indonesia during December 1997, the

financial authority ordered the closure of 16 banks in order to send the signal that insolvent

institutions would not be rescued. In February 1998, the Bank Restructuring Agency of

Indonesia (IBRA) was created. This agency immediately placed 54 banks under special

surveillance; in April 1998, it suspended the operations of 7 of these banks and intervened

managerially to 8. The interventions were made with a discretionary mandate that does not

define any procedure or time for privatization. On the other hand, due to the lack of

personnel in IBRA, the administration of 7 of the 8 banks operated by state banks lead to

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 another arrangement. In September 1998, the government receives from the intervened

banks shares that give control of more than 100 companies as payment for the emergency

loans extended to them. Thailand initiated the implementation of corrective measures in

December 1997, the first action was to involve 48 financial companies. Subsequently, at

the beginning of 1998, four commercial banks were intervened, and in May 1998, seven

other financial companies were intervened. The recapitalization of the 7 financial

companies intervened in May was carried out with a capital issue subscribed by the

Development Fund of Financial Institutions. In Malaysia, the operations of any financial

institution were not suspended and only one commercial bank and two financial companies

were intervened. The response to the banking problem has been through significant

injections of liquidity from the Central Bank into the financial system and support for

mergers. In January 1998, Central Bank deposits in financial institutions represented 13%

of GDP. It is important to note that these injections have been indiscriminately given to

insolvent institutions as well as to institutions with liquidity problems. Until March 1998,

16 financial companies were merged with 6 larger companies and 2 banks. The Central

Bank's support consisted in granting a one-year guarantee against the deterioration of the

assets of the newly acquired institutions. The guarantee applies only after an extensive

audit of the acquired financial companies.

Japan and Malaysia used predominantly private capitalization schemes with limited use of public

resources. Korea, Indonesia and Thailand committed a greater proportion of public resources for

the resolution of the crisis and the process was adequate according to the institutional framework

in order to use these resources effectively.

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In Indonesia, the authorities considered that the restructuring of private debt was an indispensable

measure to achieve adequate bank capitalization. However, this measure was not implemented due

to exchange rate instability and high interest rates. This forced several companies to default on

their domestic and external obligations.

Relaxation to regulation

In August 1992, Japan allowed banks to value shareholdings at book value instead of

registering them at market value; avoiding that the banks had to recognize losses as a result

of the fall in the price of the shares. However, following the so-called "Big Bang" reforms

of 1996, at the end of 1999 the valuation of these shareholdings should be made at market

price, which implies that the banks they will have to take the losses or increase their

provisions to cover the difference.

Another measure adopted by the government of Japan is to establish dual capitalization

requirements. Banks with international operations (the largest) have to satisfy the

capitalization of 8% that the BIS marks, while banks with national operations only have to

maintain a level of capitalization of 4%. In Indonesia, the finance ministry has ordered a

temporary reduction of capitalization requirements in the 70 banks that have not been

intervened.

The requirements are relaxed in the following way: in 1998 from 8 to 4%, in 1999 from 10

to 8%, and in the year 2000 from 12 to 10%. In Malaysia, the Central Bank relaxed banking

regulation in September 1998 after taking initial steps to strengthen it.

The relaxation measures are:

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 (1) The classification period for past due loans is extended from 3 to 6 months.

(2) The period of continuous payments required to reclassify a past due loan to the current

12 to 6 month category decreases.

(3) The obligation for banks to automatically provision 20% of the past due loans is

eliminated.

(4) Increase the limit to credits that can be granted for the purchase of shares or trusts of

commercial banks and financial companies from 15% to 20%.

Korea, Indonesia and Malaysia did not have explicit deposit insurance. Japan had a deposit

insurance with limited coverage and Thailand since before the crisis has an explicit guarantee

covering 100% of deposits. Following the crisis, all countries have been forced to guarantee all

deposits to avoid bank runs. In Indonesia, the government offered a limited guarantee of up to $

5,000 to the depositors of the first banks that suspended their operations. This measure caused

depositors to lose confidence in the banking system and the occurrence of a massive withdrawal

of deposits. Faced with this situation, the government announced a guarantee for 100% of deposits.

Even so, confidence did not recover immediately, which is why bank runs have been recurrent,

perhaps due to information problems or because of the political and social instability that exists in

this country.

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