The real lessons of the July 1997 Asian crisis: 

The real lessons of the July 1997 Asian crisis:

Understanding the 1997 Asian Crisis

Context

•  Many of the most wildly successful economies in Asia tumbled into a crisis in July 1997. They had to be bailed out by the International Monetary Fund on terms that led to a lot of political angst.

Background

•  India was also hit by the Asian crisis of 1997
•  The splendid economic boom after the 1991 economic reforms came to an end, the rupee tumbled and bad loans began to pile up in the banking sector.
•   It took five years for the Indian economy to get back on track.

Features of the Crisis

• First, countries with high fiscal deficits that were funded through money creation by the central bank would eventually see their external accounts come under pressure. India had a very similar experience in 1991
• What happened in Asia was quite different. These countries did not fall prey to fiscal profligacy.
• Their main stress points were in the private sector—too much corporate debt, a credit bubble and lax lending standards to crony capitalists.
• Second, perhaps the biggest flaw in the Asian economic strategy was that their central banks were committed to maintaining a fixed exchange rate against the dollar (or currency boards in the case of Hong Kong).
•  This meant that both foreign investors buying Asian assets as well as regional companies borrowing in dollars thought they had no foreign exchange risk.
•  The result was a gush of hot money on the one hand and a dangerous build-up of dollar liabilities in corporate balance sheets on the other.
• Asian central banks quickly ran through their foreign exchange reserves in the attempt to defend fixed exchange rates. When they eventually gave up, and allowed their currencies to fall sharply, corporate balance sheets with large dollar borrowings were in tatters.
• Third, the Asian crisis showed that financial markets are prone to herd behavior—and that currency panics can be self-fulfilling.
• Almost all the affected economies tried to deal with the crisis through massive demand compression, through a combination of higher interest rates and massive budgetary cuts. The idea was to bring capital back into the region.
•  Fourth, the deeper roots of the Asian crisis could be found in the economic models that took these countries from poverty to prosperity within a few decades.
• The entire growth in Asian output during the miracle years could be explained by perspiration rather than inspiration. In other words, the main driver of economic growth was the more extensive use of inputs such as labor and capital, rather than innovation or productivity.
•  Eventually, wages began to outpace productivity, overheated financial markets led to an sharp increase in private sector debt, and excess domestic demand flowed into the trade account in terms of higher imports.

Lessons Learnt

•  The Asian crisis of 1997 came in a lot of learning lessons. The major ones are:
•  Economic dislocations can emanate from the private sector rather than the government budget
•  Maintaining fixed exchange rates in a world of free capital flows is almost impossible
•  Currency panics can be self-fulfilling, so capital controls should be used in rare cases as an emergency tool
•  Countries need to think deeply about their economic development models, especially if they have become outdated as they move up the value chain.

Mitigating the Crisis

•  The Asian tigers eventually bounced back—but they have never been able to match the performance of the years before the crisis.
•  The structural transformation of these economies can perhaps best be seen in the story of the Korean chaebol (*), such as Samsung or Hyundai, which reinvented themselves as engines of global innovation
•   China is in the middle of a similar transition right now.
•    It remains to be seen whether it can change its economic model without severe disruption.

India’s Position

•  It is still at a stage of development when it needs to put more capital and labor to work
•  In other words, India needs to maintain a high investment rate as well as create jobs to allow people to shift to modern sectors that have high productivity

What is Korean chaebol?(*)

A chaebol  is a South Korean form of business conglomerate. They are typically global multinationals and own numerous international enterprises, controlled by a chairman with power over all the operations. The term is often used in a context similar to that of the English word “conglomerate”.