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The Crisis in Southeast Asia

In 1997 most countries in Southeast Asia were affected by a far-reaching economic crisis which had a decisive impact on the development of global capital markets. The crisis began as a currency crisis, but soon spread to the affected countries' financial markets and institutions, and to output and employment.

In recent years there has been a considerable influx of capital to the Southeast Asian economies - primarily Thailand, Malaysia, Indonesia, the Philippines and Singapore - against the background of strong economic growth and substantial fixed investments. In several of the countries the strong growth has given rise to inflationary pressure and external disequilibria. All of these countries, with the exception of Singapore, thus had current-account deficits of between 31/2 per cent and 8 per cent of GDP in 1996.

Before the crisis the general objective of the exchange-rate policies of these countries was to stabilize their currencies vis-ā-vis a basket of currencies in which the dollar carried most weight. The strengthening of the dollar vis-ā-vis the yen and the European currencies throughout 1996 and in the first half of 1997 weakened these countries' competitiveness considerably. In addition, competition from e.g. India and China intensified.

To a great extent the current-account deficits were financed on a short-term basis via the foreign borrowing of private business enterprises and banks. Confidence in the countries' fixed-exchange-rate policies meant that loans at low interest rates were unhedged.

The far-reaching crisis began in Thailand. In the spring of 1997 the sustainability of the fixed exchange rate came into doubt and a risk emerged of higher expenditure to service the foreign debt. Domestic demand for foreign exchange therefore increased and the exchange rate came under pressure. There are no indications that the foreign-exchange crisis was provoked by foreign market participants taking speculative positions.

In the first half of 1997 Thailand's central bank undertook massive intervention in the foreign-exchange market, but as a consequence of increasing pressure on the baht Thailand on July 2 allowed its currency to float. The baht immediately weakened considerably against the dollar, cf. Chart 25. Soon afterwards Indonesia, Malaysia and the Philippines abandoned their fixed-exchange-rate policy and their currencies subsequently weakened significantly against the dollar.

After the collapse of the fixed-exchange-rate policy a chain reaction started on the increase - measured in domestic currency - in the private non-financial sector's foreign debt. A large proportion of this debt

comprised short-term loans denominated in dollars and it became increasingly difficult to refinance the short-term foreign debt. Liquidity conditions thus became very tight and as a consequence many business enterprises had difficulty in meeting their obligations to the financial sector. The banks' solvency and credit standing generally deteriorated as a result of the non- performing loans as well as higher expenditure on the banks' own foreign loans. The currency crisis soon spread to the share markets of the affected countries, cf. Chart 26. The drop in share prices in the East Asian countries reflects the outflow of capital as the currencies weakened. To offset this weakening the central banks allowed short-term interest rates to rise. The rising interest rates also contributed to the drop in share prices.

In August an IMF loan to support Thailand's ailing economy was approved, followed by a loan to Indonesia in November.

In mid-October the currency unrest spread to Hong Kong and South Korea. The Hong Kong dollar came under pressure, but the authorities successfully defended the currency by allowing interest rates to rise. On the other hand, share prices plummeted. During October the benchmark share index dropped by approximately 30 per cent. The falling share prices in Hong Kong caused stock markets in the USA and Europe to drop as well.

The South Korean currency also came under pressure at the end of October. In mid-November the government had to abandon its exchange-rate policy and the day-to-day fluctuation band was widened from 21/4 per cent to 10 per cent. In mid-December the fluctuation band was abandoned entirely in accordance with the terms of the agreement with the IMF. At the beginning of December the IMF and South Korea concluded a loan agreement. The agreement is described on p. 85ff. As a consequence of the foreign-exchange crisis and the problems it entailed for the business enterprises and the banks share prices on the South Korean stock exchange fell by just over 45 per cent from October to the end of the year.

A particular problem faced by the economies of the crisis-torn countries has been the combination of substantial potential for growth and relatively underdeveloped financial sectors. Factors characterizing the financial institutions include inadequate internal control and management of risk exposures. In addition, external supervision of financial institutions is relatively inefficient. The result is haphazard management of both domestic savings and foreign capital inflows.

It is very likely that the crisis in the financial sectors will affect future credit granting. The combination of substantial non-performing loans and reduced capital adequacy will probably cause the banks to pursue a more restrictive credit-granting policy. In the short term this may amplify the economic slowdown in these countries. In the longer term the strong depreciation of the currencies and the efforts in some of the countries to liberalize and reconstruct the economies may contribute to a revival of growth in the region.