Lessons learned from Asian crisis still at play

Twenty years on the harsh lessons of the Asian Financial Crisis (AFC) are never far from the minds of policymakers.

Today, economic fundamentals in previously crisis-hit countries are currently in much better shape and the vulnerabilities which led to the crisis are no longer present.

External debt as a percentage of GDP has improved. Current account surpluses are now the norm with the exception of Indonesia. FX reserve buffers have been built up. 

Importantly, sound institutional frameworks have been implemented, including flexible exchange rate regimes, inflation targeting, fiscal discipline and vigilance towards the build-up of financial system risks. 

"The ASEAN-4 and South Korea are now less vulnerable to shocks and better placed.”  - Khoon Goh

As a result, the ASEAN-4 and South Korea are now less vulnerable to shocks and better placed to face continued policy normalisation from the US Federal Reserve. The focus now is on reforms to raise potential growth and manage the cyclical challenges facing the economies.

Shock

On July 2 1997, the Bank of Thailand (BoT) was forced to float the Thai baht after it could no longer defend the currency and maintain its narrow peg to the $US. The baht depreciated by 16 per cent that day, heralding the start of the AFC.

As contagion spread across the region and foreign investors withdrew their capital economic activity contracted sharply.

The economies of Thailand, Indonesia, South Korea, and Malaysia were the most adversely impacted, with all barring the latter requiring assistance from the International Monetary Fund (IMF).

Prior to the crisis, strong economic growth prior to the AFC helped mask growing vulnerabilities which ultimately led to trouble.

The combination of strong economic growth and stable exchange rates saw rapid capital inflows. This led to strong credit expansion and pushed asset prices higher initially, including a rise in the real effective exchange rates as local currencies kept pace with a stronger $US.

Local corporates increased their overseas borrowing denominated in foreign currency – the so-called ‘original sin’. Expectations currencies would remain stable against the dollar resulted in a large build-up in unhedged foreign currency exposures.

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Improvement

The contrast between the current situation compared to 1997 could not be more stark. Important changes were made to economic management following the AFC. Exchange rate regimes were made more flexible and allowed to respond to external shocks.

Although high inflation was not a major issue prior to the AFC, central banks have nonetheless been given greater independence and have adopted inflation targeting as their principal policy objective.

Importantly, regional central banks have been vigilant towards any build-up of financial risks in the system, ensuring that there is no repeat of the events of twenty years ago.

Fiscal discipline has been one of the major improvements in the region. Deficit and debt-to- GDP targets have been brought in to provide transparency and predictability.

Closer regional cooperation to manage any future crisis were also developed, with the Chiang Mai Initiative Multilateralisation (CMIM) comprising currency swap agreements among ASEAN countries and South Korea, Hong Kong, China, and Japan.

The improved macroeconomic fundamentals as well as institutional frameworks are reflected in the sovereign credit ratings.

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The new challenge

Diminished external vulnerabilities and improved economic management notwithstanding, these economies are now confronted with a new challenge – raising potential growth and per capita incomes against a backdrop of structurally weaker global trade.

Raising potential growth is particularly challenging for South Korea and Thailand, both of whom face a worsening demographic profile.

The burden of raising potential growth is therefore becoming contingent upon augmenting productivity. Unfortunately, growth in total factor productivity (TFP) has weakened in the post-global financial crisis period, somewhat in tandem with slowing global trade.

Still, the ASEAN-4 and South Korea are now less vulnerable to shocks due to improved fundamentals and institutional frameworks. In ANZ’s view they are well placed to face continued policy normalisation from the US Federal Reserve.

The work of raising the economy’s defences has largely been done. The focus now is on reforms to raise potential growth and manage the cyclical challenges mentioned above.

Khoon Goh is Head of Asia Research at ANZ

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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