The Crisis

The Asian meltdown began in mid-1997 in Thailand when it became clear that several key Thai financial institutions were on the verge of default (see the closing case to Chapter 9 for more details). These institutions had been borrowing dollars from international banks at low interest rates and lending Thai baht at higher interest rates to local property developers. However, due to speculative overbuilding, these developers could not sell their commercial and residential property, forcing them to default on their debt obligations. In turn, the Thai financial institutions seemed increasingly likely to default on their dollar-denominated debt obligations to international banks. Sensing the beginning of the crisis, foreign investors fled the Thai stock market, selling their positions and converting them into US dollars. The increased demand for dollars and increased supply of Thai baht, pushed down the dollar/Thai baht exchange rate, while the stock market plunged.

Seeing these developments, foreign exchange dealers and hedge funds started speculating against the baht, selling it short. For the previous 13 years, the Thai baht had been pegged to the US dollar at an exchange rate of about $1=Bt25. The Thai government tried to defend the peg, but only succeeded in depleting its foreign exchange reserves. On July 2, 1997, the Thai government abandoned its defense and announced it would allow the baht to float freely against the dollar. The baht started a slide that would bring the exchange rate down to $1=Bt55 by January 1998. As the baht declined, the Thai debt bomb exploded. The 55 percent decline in the value of the baht against the dollar doubled the amount of baht required to serve the dollar-denominated debt commitments taken on by Thai financial institutions and businesses. This increased the probability of corporate bankruptcies and further pushed down the battered Thai stock market. The Thailand Set stock market index ultimately declined from 787 in January 1997 to a low of 337 in December of that year, on top of a 45 percent decline in 1996.

On July 28, the Thai government called in the International Monetary Fund. With its foreign exchange reserves depleted, Thailand lacked the foreign currency needed to finance its international trade and service debt commitments and desperately needed of the capital the IMF could provide. It also needed to restore international confidence in its currency and needed the credibility associated with gaining access to IMF funds. Without IMF loans, the baht likely would increase its free fall against the US dollar, and the whole country might go into default. The IMF agreed to provide the Thai government with $17.2 billion in loans, but the conditions were restrictive.²⁸ The IMF required the Thai government to increase taxes, cut public spending, privatize several state-owned businesses, and raise interest rates--all steps designed to cool Thailand's overheated economy. The IMF also required Thailand to close illiquid financial institutions. In December 1997, the government shut 56 financial institutions, laying off 16,000 people, and further deepening the recession that now gripped the country.

Following the devaluation of the Thai baht, wave after wave of speculation hit other Asian currencies. One after another in a period of weeks, the Malaysian ringgit, Indonesian rupiah, and the Singapore dollar were all marked sharply lower. With its foreign exchange reserves down to $28 billion, Malaysia let the ringgit float on July 14, 1997. Before the devaluation, the ringgit was trading at $1=2.525 ringgit. Six months later it had declined to $1=4.15 ringgit. Singapore followed on July 17, and the Singapore dollar quickly dropped in value from $1=S$1.495 before the devaluation to $1=S$2.68 a few days later. Next up was Indonesia, whose rupiah was allowed to float August 14. For Indonesia, this was the beginning of a precipitous decline in the value of its currency, which was to fall from $1=2,400 rupiah in August 1997 to $1=10,000 rupiah on January 6, 1998, a loss of 75 percent.

With the exception of Singapore, whose economy is probably the most stable in the region, these devaluations were driven by factors similar to those behind the earlier devaluation of the Thai baht--a combination of excess investment, high borrowings, much of it in dollar-denominated debt, and a deteriorating balance-of-payments position. Although both Malaysia and Singapore were able to halt the slide in their currencies and stock markets without the help of the IMF, Indonesia was not. Indonesia was struggling with a private-sector, dollar-denominated debt of close to $80 billion. With the rupiah sliding precipitously almost every day, the cost of servicing this debt was exploding, pushing more Indonesian companies into technical default. 

On October 31, 1997, the IMF announced that it had put together a $37 billion rescue deal for Indonesia in conjunction with the World Bank and the Asian Development Bank. In return, the Indonesian government agreed to close a number of troubled banks, reduce public spending, remove government subsidies on basic foodstuffs and energy, balance the budget, and unravel the crony capitalism that was so widespread in Indonesia. But the government of President Suharto appeared to backtrack several times on commitments made to the IMF. This precipitated further declines in the Indonesian currency and stock markets. Ultimately, Suharto caved in and removed costly government subsidies, only to see the country dissolve into chaos as the populace took to the streets to protest the resulting price increases. This unleashed a chain of events that led to Suharto's removal from power in May 1998.

The final domino to fall was South Korea (for further details, see the Country Focus in Chapter 9). During the 1990s, South Korean companies had built up huge debt loads as they invested heavily in new industrial capacity. Now they found they had too much industrial capacity and could not generate the income required to service their debt. South Korean banks and companies had also made the mistake of borrowing in dollars, much of it in the form of short-term loans that would come due within a year. Thus, when the Korean won started to decline in the fall of 1997 in sympathy with the problems elsewhere in Asia, South Korean companies saw their debt obligations balloon. Several large companies were forced to file for bankruptcy. This triggered a decline in the South Korean currency and stock market that was difficult to halt. The South Korean central bank tried to keep the dollar/won exchange rate above $1 = W1,000 but found that this only depleted its foreign exchange reserves. On November 17, the Korean central bank gave up the defense of the won, which quickly fell to $1=W1,500.

With its economy of the verge of collapse, the South Korean government on November 21 requested $20 billion in standby loans from the IMF. As the negotiations progressed, it became apparent that South Korea was going to need far more than $20 billion. Among other problems, the country's short-term foreign debt was found to be twice as large as previously thought at close to $100 billion, while the country's foreign exchange reserves were down to less than $6 billion. On December 3, the IMF and South Korean government reached a deal to lend $55 billion to the country. The agreement with the IMF called for the South Koreans to open their economy and banking system to foreign investors. South Korea also pledged to restrain the chaebol by reducing their share of bank financing and requiring them to publish consolidated financial statements and undergo annual independent external audits. On trade liberalization, the IMF said South Korea will comply with its commitments to the World Trade Organization to eliminate trade-related subsidies and restrictive import licensing and will streamline its import certification procedures, all of which should open the South Korean economy to greater foreign competition.²⁹