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THE 1990s ASIAN FINANCIAL CRISIS

This section on the 1990s East and Southeast Asian financial crisis (the “Asian financial crisis”) examines the challenges the crisis posed to the IMF and inter- national financial stability, and proposals to improve the “international financial architecture.” Chapter 10 discusses this crisis in the context of inter- national development. As discussed, international bank lending to LDCs sharply declined during the 1980s as a result of the foreign debt crisis. In the 1990s, private capital flows to middle-income LDCs increased again, but there was a change in the source of capital. Whereas commercial bank lending was the primary source of capital in the 1970s and 1980s, portfolio investment, or the purchase of stocks, bonds, and money market instruments by foreigners, was much more important in the 1990s. Foreign direct investment, or the foreign ownership or control of assets, also increased during the 1990s (see Chapter 9). Indeed, the net private capital flows to 29 emerging market economies increased from $35 billion in 1990 to $334 billion in 1996. (Emerging market economies are LDCs able to attract private capital flows.)69 This revival of capital flows resulted from LDC economic reforms in response to the debt crisis, the success of the Brady Plan debt reductions, higher interest rates in the South, and a freeing of capital controls on investment in LDCs. However, some economists warned that these capital flows were volatile and “could be reversed easily.”70 Their concerns were soon realized when capital flows to Mexico halted rather suddenly in 1994. This section focuses mainly on the 1997–1999 Asian financial crisis, which “was the sharpest financial crisis to hit the developing world since the 1982 debt crisis.”71

The Asian financial crisis began in Thailand in July 1997, when there was a massive run on its currency, the baht. The roots of this crisis can be traced to the early 1990s, when capital inflows to Thailand rose sharply even though its current account deficit was increasing, its property prices were declining, and Thai banks were incurring a sizable foreign currency debt. Like other East Asian currencies, the baht was pegged to the U.S. dollar, and Thai exports became less competitive when the dollar’s exchange rate rose against the Japanese yen. Thus, Thailand had to allow its baht to float because of downward pressure on the currency. Despite government efforts to bolster the baht, capital outflows caused the currency to lose 48.7 percent of its value over the next six months, and this resulted in a sharp decrease in the country’s assets and growth. After the baht began to depreciate, the currencies of Indonesia, South Korea, Malaysia, the Philippines, and Singapore also came under severe downward pressure. The widening of the crisis from Thailand to other Asian countries is referred to as financial contagion, or the transmission of a financial shock from one market or

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country to other interdependent markets or countries. The financial contagion was manifested in several ways. All of these countries experienced rapid outflows of capital, depreciation of their currencies, and dramatic declines in their stock markets. Most of these countries also had recessions, banking crises, and lower economic growth rates. Thus, Thailand, Indonesia, and South Korea had to seek IMF and World Bank loans to bolster their currencies and economies. The economic problems also led to political problems, with major demonstrations leading to the resignation of Indonesia’s president Suharto, and transfers of power in Thailand, South Korea, and the Philippines.72

The main problems in the 1980s debt crisis were the overall indebtedness and high debt-service ratios of many LDC governments. However, in the Asian financial crisis the debts of governments such as Thailand, Indonesia, and South Korea to private and official creditors were relatively small. Domestic banks and private companies in Asia, by contrast, had borrowed heavily from foreign creditors, and when capital flows were reversed the Asian governments faced the challenge of overhauling insolvent banking systems and restructuring corporate debt. In sum, while the 1980s debt crisis resulted from “unsustain- able current account deficits and poor macroeconomic fundamentals,” the Asian crisis was basically a “capital account crisis.”73 Although the financial crisis proved to be only a temporary setback and the Asian economies generally resumed their rapid growth rates, there were concerns that financial crises could recur because of the increased capital flows. Thus, the major DC governments proposed a number of reforms to strengthen global governance in finance, or the international financial architecture.74

The annual G7 summits played an important role in the architecture exercise, which began in 1995 in response to the Mexican financial crisis and evolved in response to the Asian crisis and a financial crisis in Russia. The architecture exercise led to the creation of new IMF lending facilities, efforts to strengthen the financial infrastructure in LDCs and transition economies, and a debate regarding the role of the IMF and its conditionality requirements. The main objectives were to develop better strategies to prevent and resolve finan- cial crises. Crisis prevention involved identifying vulnerable countries before they experienced crises and fostering compliance with international standards to increase financial stability. Crisis resolution involved reforming IMF policies and involving private creditors in efforts to resolve financial problems of LDCs and transition economies.75 Prescriptions for the best measures to reform the international financial architecture depend on one’s theoretical perspective, and the following discussion compares the views of four groups:

1. Orthodox liberals. 


2. Those combining orthodox and institutional liberalism. 


3. Those combining interventionist and institutional liberalism. 


4. Historical materialists.76 
The first group of scholars are orthodox liberals who see the problems 


with international finance as stemming from inadequate domestic institutions and policies, not from the freeing of capital flows. From this perspective, the

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1994 Mexican peso crisis resulted from an overvalued exchange rate and inadequate attention to the country’s trade and budget deficits and foreign debt; the 1997 Asian financial crisis stemmed from inaccurate financial reporting, pegged exchange rates, and banks offering questionable loans to businesses with political connections. Freer global capital flows were not responsible for the Asian financial problems. On the contrary, capital flows maximize efficiency because they are directed to countries with balanced budgets, stable markets, and low inflation rates. International regulation to limit risky behavior in capital markets would be harmful, and all capital controls should be abolished. Some economists believe that a lender of last resort is necessary for states with financial problems and that the IMF could perform this function if it had more financial resources. A lender of last resort “is an institution that is willing and able to supply unlimited amounts of short-term credit to financial institutions when they are threatened by a creditor panic.”77 However, orthodox liberals argue that the best way to prevent capital flight and speculative attacks on a state’s currency is to eliminate the problem of moral hazard. Moral hazard refers to the idea that protection against risk encourages a person or state to engage in riskier behavior. If a lender of last resort exists, states facing financial crises are more likely to engage in risky behavior because they can count on the lender to rescue them. Some orthodox liberals criticize the IMF and the Bank for contributing to moral hazard by providing development assistance, debt bailouts, and balance-of-payments support.

The second group of scholars combines orthodox and institutional liberalism. Like the first group, they believe that inadequate domestic policies increase a country’s vulnerability to financial crises, and that the Asian financial crisis stemmed more from “crony capitalism” or overly close connections between business and government than from financial contagion. Unlike the first group, however, they also see an important role for the IMF and World Bank in ensuring that LDCs and transition economies follow transparent, liberal economic policies. They favor strong IMF conditionality requirements to ensure that states are sub- ject to the discipline of the marketplace, and IMF policies that “legitimize financial liberalization” and block efforts to increase “state regulation of international financial flows.”78

The third group combines interventionist and institutional liberalism. As liberals, they assume that the failure of countries to follow liberal economic policies interferes with efficiently functioning markets. As interventionist liberals, they believe that unrestrained markets are not beneficial and that measures must be taken to protect society (see Chapter 4). In finance, currency traders often buy and sell for profit without taking account of fundamental economic conditions, and this produces volatility in capital flows and foreign exchange markets. Thus, financial markets are likely to perform better when regulated. The third group also emphasizes the need for a well-funded interna- tional lender of last resort to prevent financial crises from damaging global economic efficiency and development in LDCs and transition economies.79 Theorists in this group have been actively involved in debates regarding the

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international financial architecture. For example, some members of this group responded to the Asian financial crisis by supporting the Tobin tax, which Nobel Laureate James Tobin first proposed in 1972. Tobin’s proposal called for “an internationally uniform tax on all spot conversions of one currency into another, proportional to the size of the transaction.”80 Although Tobin recommended a tax of only 1 percent, he believed that it would discourage short-term speculative capital flows and generate revenue that could be used for purposes such as combating world poverty. Supporters of the Tobin tax argue that it would reduce the risk of global financial crises and provide the international community with some of the profits flowing from international capital mobility. However, critics of the Tobin tax range from orthodox liberals who insist there is nothing wrong with the financial markets, to others who argue that such a tax would not be effective. Whereas currency traders in times of crisis would disregard a small tax, a larger tax would seriously interfere with financial markets.81 As institutional as well as interventionist liberals, the third group proposes numerous reforms in IMF and World Bank transparency, accountability, and conditionality requirements. They also support the idea that the IMF should become a lender of last resort.82

The fourth group of scholars are historical materialists who view the Asian financial crisis as another example of the corrupting power of international capital. Unlike interventionist liberals, they see the IMF and the Bank as unreformable, and (like some orthodox liberals) they therefore favor the abolition of these institutions. For example, one study concludes that “the international financial institutions require Third World countries to adopt policies that harm the interests of working people.”83

Until recently, the second group (orthodox and institutional liberals) had the most influence in discussions of the international financial architecture.84 However, the third group (interventionist and institutional liberals) has been gaining more influence as a result of the global financial crisis which began in the first decade of the twenty-first century.