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Unit 26 : East Asian Crisis and Lessons for Developing Countries

companies had large debts denominated in dollars. If the countries simply allowed their currencies Notes
to drop, rising import prices would threaten to produce dangerous inflation, and the sudden increase
in the domestic-currency value of debts might push many potentially viable banks and companies
into bankruptcy. On the other hand, to defend the currencies would require at least temporary high
interest rates to persuade investors to keep their money in the country, and these high interest rates
would themselves produce an economic slump and cause banks to fail.
All of the afflicted countries except Malaysia turned to the IMF for assistance and received loans in
return for implementation of economic plans that were supposed to contain the damage : higher
interest rates to limit the exchange rate depreciation, efforts to avoid large budget deficits, and
“structural” reforms that were supposed to deal with the weaknesses that had brought on the crisis
in the first place. Despite the IMF’s aid, however, the result of the currency crisis was a sharp economic
downturn. All of the troubled countries went from growth rates in excess of 6 percent in 1996 to a
severe contraction in 1998.
Worst of all was the case of Indonesia, where economic crisis and political instability reinforced each
other in a deadly spiral, all made much worse by a collapse of confidence by domestic residents in the
nation’s banks. By the summer of 1998 the Indonesian rupiah had lost 85 percent of its original value,
and few if any major companies were solvent. The Indonesian population was faced with mass
unemployment and, in some cases, with inability to afford even basic foodstuffs. Ethnic violence
broke out.
As a consequence of the collapse of confidence, the troubled Asian economies were also forced into a
dramatic reversal of their current account positions : They moved abruptly from sometimes large
deficits to huge surpluses. Most of this reversal came not through increased exports but through a
huge drop in imports, as the economies contracted.
Currencies stabilized throughout crisis-stricken Asia and interest rates decreased, but the direct
spillover from the region’s slump caused slowdowns or recessions in several neighboring countries,
including Hong Kong, Singapore, and New Zealand. Japan and even parts of Europe and Latin
America were feeling the effects. Most governments continued to take IMF-prescribed medicine, but
in September 1998 Malaysia—which had never accepted an IMF program—broke ranks and imposed
extensive controls on capital movements, hoping that the controls would allow it to ease monetary
and fiscal policy without sending its currency into a tailspin. China and Taiwan, which maintained
capital controls and had current account surpluses over the pre-crisis period, went largely unscathed
in the crisis.
Fortunately, the downturn in East Asia was “V-shaped” : After the sharp output contraction in 1998,
growth returned in 1999 as depreciated currencies spurred higher exports. Not all of the region’s
economies fared equally well, and controversy remains over the effectiveness of Malaysia’s experiment
with capital controls. In general, investment rates have remained depressed and current accounts
have remained in surplus, sometimes substantially so.
Spillover to Russia
Asia’s woes sparked a general flight by investors from emerging markets, putting severe pressure on
the economic policies of distant developing nations. Russia was affected soon after.
Starting in 1989, the countries of the Soviet bloc, and ultimately the Soviet Union itself, shook off
communist rule and embarked on transitions from centrally planned economic allocation to the market.
These transitions were traumatic, involving rapid inflation, steep output declines, and a phenomenon
that had been largely unknown in planned economies—unemployment. Such beginnings were
inevitable. In most of the formerly communist countries nearly the entire economy had to be privatized.
Financial markets and banking practices were largely unknown, there was no legal framework for
private economic relations or corporate governance, and initial property rights were ambiguous.
States lacked the modern fiscal machinery through which industrial countries design and collect
taxes, and given the cautious attitude of foreign investors and the absence of domestic capital markets,
the monetary printing press was the only way to finance needed social expenditures.

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