Credit bubbles and fixed currency exchange rates

In the mid-1990s, Thailand, Indonesia and South Korea had large private current
account deficits, and the maintenance of fixed exchange rates encouraged external borrowing
, leading to excessive exposure to foreign exchange risk in both the financial and corporate
sectors.

At this same time, a series of external shocks began to change the economic environment.
The devaluation of the Chinese renminbi, and the Japanese yen due to the Plaza Accord of
1985, the raising of U.S. interest rates which led to a strong U.S. dollar, and the sharp decline
in semiconductor prices, all adversely affected their growth.As the U.S. economy recovered
from a recession in the early 1990s, the U.S. Federal Reserve Bank under Alan
Greenspan began to raise U.S. interest rates to keep inflation in check.

This made the United States a more attractive investment destination in comparison to
Southeast Asia, which had been attracting hot money flows through high short-term interest
rates, and raised the value of the U.S. dollar. For the Southeast Asian nations which had
currencies pegged to the U.S. dollar, the higher U.S. dollar caused their own exports to
become more expensive and less competitive in the global markets. At the same time,
Southeast Asia's export growth slowed dramatically in the spring of 1996, deteriorating their
current account position.

Some economists have advanced the growing exports of China as a factor contributing to
ASEAN nations' export growth slowdown, though these economists maintain the main cause
of their crises was excessive real estate speculation. China had begun to compete effectively
with other Asian exporters particularly in the 1990s after the implementation of a number of
export-oriented reforms. Other economists dispute China's impact, noting that both ASEAN
and China experienced simultaneous rapid export growth in the early 1990s.

Many economists believe that the Asian crisis was created not by market psychology or
technology, but by policies that distorted incentives within the lender–borrower relationship.
The resulting large quantities of credit that became available generated a
highly leveraged economic climate, and pushed up asset prices to an unsustainable level.
These asset prices eventually began to collapse, causing individuals and companies
to default on debt obligations.

Panic among lenders and withdrawal of credit

The resulting panic among lenders led to a large withdrawal of credit from the crisis
countries, causing a credit crunch and further bankruptcies. In addition, as foreign investors
attempted to withdraw their money, the exchange market was flooded with the currencies of
the crisis countries, putting depreciative pressure on their exchange rates. To prevent
currency values collapsing, these countries' governments raised domestic interest rates to
exceedingly high levels (to help diminish flight of capital by making lending more attractive
to investors) and intervened in the exchange market, buying up any excess domestic currency
at the fixed exchange rate with foreign reserves. Neither of these policy responses could be
sustained for long.

Very high interest rates, which can be extremely damaging to a healthy economy, wreaked
further havoc on economies in an already fragile state, while the central banks were
haemorrhaging foreign reserves, of which they had finite amounts. When it became clear that
the tide of capital fleeing these countries was not to be stopped, the authorities ceased
defending their fixed exchange rates and allowed their currencies to float. The resulting
depreciated value of those currencies meant that foreign currency-
denominated liabilities grew substantially in domestic currency terms, causing more
bankruptcies and further deepening the crisis.

The events in Thailand prompted investors to reassess and test the robustness of currency
pegs and financial systems in the region. The result was a wave of currency depreciations and
stock market declines, first affecting Southeast Asia, then spreading to the rest of the region.

Despite the clear evidence of increased external vulnerability and symptoms of financial
instability, particularly in Thailand, foreign investors continued to pour funds into the region,
and sovereign credit ratings remained extremely favourable until early 1997, when pressures
mounted and reserves fell rapidly as net capital inflows were not sufficient to meet the
widening current account deficits. The crisis broke out in early July 1997, when the Bank of
Thailand could no longer maintain the currency within the fluctuation band in view of
massive withdrawal of funds.

Lack of incentives for risk management

Two characteristics common in countries that have experienced financial crises were
present in a number of East Asian economies. First, financial intermediaries were not
always free to use business criteria in allocating credit. In some cases, well-
connected borrowers could not be refused credit; in others, poorly managed firms
could obtain loans to meet some government policy objective. Hindsight reveals that
the cumulative effect of this type of credit allocation can produce massive losses.

Second, financial intermediaries or their owners were not expected to bear the full
costs of failure, reducing the incentive to manage risk effectively. In particular,
financial intermediaries were protected by implicit or explicit government guarantees
against losses, because governments could not bear the costs of large shocks to the
payments system (McKinnon and Pill 1997) or because the intermediaries were
owned by “Ministers’ nephews” (Krugman 1998). Krugman points out that such
guarantees can trigger asset price inflation, reduce economic welfare, and ultimately
make the financial system vulnerable to collapse.