Asian Financial Crisis

Context/Description: The "Asian Tiger" economies (Thailand, Indonesia, South Korea, Malaysia, Philippines) experienced remarkable growth in the 1980s-90s through export-driven industrialization and foreign investment. To encourage stability and investment, these countries pegged their currencies to the U.S. dollar at fixed rates. "Hot money"—short-term speculative capital—flooded in seeking high returns. The borrowing was often unhedged (in dollars, for projects earning local currency). "Crony capitalism" meant banks lent to politically connected developers for questionable real estate projects.

Warning Signs:

• Current account deficits reaching 8% of GDP in Thailand
• Massive short-term foreign debt, often unhedged
• Real estate bubbles in Bangkok, Jakarta, Seoul
• Export growth slowing as China competed and the dollar strengthened
• Bank balance sheets deteriorating with bad real estate loans
• Thailand's foreign reserves depleting as it defended the baht peg
• Currency speculators (including George Soros) betting against pegs

The Problem: The fixed currency pegs created moral hazard—borrowers assumed exchange rates wouldn't change. When exports slowed and real estate bubbles peaked, foreign investors began withdrawing capital. Countries had insufficient reserves to maintain currency pegs against speculative attacks. Banking sectors were undercapitalized with high non-performing loans.

The Trigger: On July 2, 1997, Thailand abandoned its baht-dollar peg after depleting foreign reserves defending it. The baht immediately plummeted. Currency traders recognized other Asian economies had similar vulnerabilities.

The Cascade: Classic financial contagion spread across the region:

• Investors fled all Asian markets indiscriminately ("when one goes, they all go")
• Currency devaluations made dollar-denominated debts unpayable
• Bank runs and financial sector collapses
• Corporate bankruptcies as companies couldn't service foreign debt
• IMF imposed strict austerity conditions for bailout loans
• Social unrest as unemployment soared and standards of living collapsed
• Political instability: Indonesia's Suharto regime fell in 1998

The crisis spread beyond Asia: Russia defaulted in August 1998 (partly due to falling commodity prices from Asian demand collapse), and the Long-Term Capital Management (LTCM) hedge fund collapsed in September 1998, requiring a Fed-orchestrated bailout to prevent global contagion.

Results/Impacts:

• Currencies fell 30-80% against the dollar
• Stock markets dropped 50-75%
• GDP contracted severely: Indonesia -13%, Thailand -10%, South Korea -6%
• Unemployment skyrocketed; poverty rates doubled or tripled
• Social impacts: Rising suicide rates, malnutrition, delayed marriages
• Political changes: Suharto's fall in Indonesia; reformist governments elsewhere
• IMF provided $110 billion in bailout packages with controversial austerity conditions

Long-Term Changes:

• Countries adopted floating exchange rates
• Built up massive foreign reserves to prevent future attacks
• Corporate governance reforms
• Banking sector restructuring
• Skepticism of IMF-style austerity; search for Asian alternatives
• Accelerated regional cooperation efforts

The Lesson: Fixed exchange rates with open capital flows create crisis vulnerability (the "impossible trinity"). Currency pegs encourage excessive foreign borrowing without proper hedging. Contagion can spread based on investor psychology rather than fundamental linkages. IMF austerity can deepen recessions. Crony capitalism and weak financial regulation invite disaster.