n 1997, a financial crisis threw the East Asian economies into a financial chaos that threatened to derail the East Asian economic miracle and engulf the global financial system. In the 1990s, East Asia had become the scene of a new group of economic miracles. From the mid1990s until the outbreak of financial crisis, East Asian countries such as Thailand, Singapore, Indonesia, South Korea, and Malaysia posted real gross domestic product (GDP) growth rates in the 8 percent range or higher (International Monetary Fund, 1997).
Until the East Asian financial crisis, currency crises were often the domain of countries suffering from high inflation, slow growth, large government budget deficits, low savings, and political instability. Unlike the usual candidates for currency crises, the East Asian countries had what economists call “sound macroeconomic fundamentals.” They had high savings rates, low public debts, fast growth and low inflation—the very qualities that win the confidence of foreign investors.
One crack in the foundation involved the structure of corporate finance. Enterprises had relied too heavily on debt financing as opposed to stock issuance. Enterprises do not face bankruptcy when the value of company stock plunges, but they do face bankruptcy when they cannot pay debts. An equally important vulnerability stemmed from the balance sheets of East Asian banks. These banks borrowed foreign capital on a short-term basis to underwrite long-term loans. The short-term nature of the foreign capital inflows left these banks open to a sudden and unexpected reversal from a foreign capital inflow to a foreign capital outflow. A sudden reversal of foreign capital flows made these banks and enterprises illiquid. Much of the foreign debt was denominated in dollars. When the exchange rates of local currencies fell, the real value of foreign debt in local currencies skyrocketed.
The East Asian countries practiced an economic policy that pegged the value of their local currencies to a basket of currencies in which the U.S. dollar played a highly dominate role. The rate at which a local currency could be converted into dollars remained almost constant. This policy shared in making East Asia an attractive haven for foreign capital, but it also was the undoing of these economies. In the late 1990s, the value of the U. S dollar went up, probably because of strong global demand for U.S. financial assets. As the value of the dollar climbed, the values of currencies linked to the dollar, such as the East Asian currencies, also climbed. The appreciation of a country’s currency leaves the exports of that country more expensive in foreign markets. It also makes foreign imports into that country less costly. Falling exports and rising imports left the East Asian economies with current account deficits that needed to be financed by an inflow of foreign capital. East Asian companies began to feel the pain as sales fell off in foreign markets, and domestic sales faced greater completion from imports. In addition, East Asian central banks raised interest rates to increase the attraction for foreign capital. The policy of keeping the local currency exchange rates pegged to the dollar required that current account deficits be financed by foreign capital inflows. Otherwise, the value of the local currency relative to the dollar would sink.
The economic and financial situation in Thailand sparked the crisis. Many currency traders believed that the baht, Thailand’s currency, traded too high, higher than the central bank of Thailand could support.
Thailand’s economy was already suffering from double-digit interest rates and depressed stock prices. Currency traders launched billions of dollars of sell contracts on the baht. Fears of currency depreciation excited a broad outflow of foreign capital, putting more pressure on foreign exchange reserves. In a single day, the central bank spent $500 million dollars of its dollar reserves to keep the baht from falling below its pegged level (Daniels and VanHoose, 1999, 441). In 1997, Thailand’s central bank let the baht float, free to depreciate, which it did.
The depreciation of the baht triggered foreign capital outflows from other East Asian economies. By the end of 1997, Thailand, Indonesia, and South Korea had watched local currencies depreciate about 40 percent relative to the U.S. dollar (Daniels and VanHoose, 1999, 36).
See also: Currency Crises
