A CLOSER LOOK TO SOUTHEAST ASIAN FINANCIAL CRISIS IN 1997 AND THE LESSONS FOR VIETNAM International Finance

The purpose of our paper “A closer look to Southeast Asian financial crisis in 1997 and the lessons for Vietnam” is to analyze the causes and consequences of the East Asian financial and currency crisis with the view to discovering whether intrinsic instabilities in the international capital markets helped either set it in motion or deepen the crisis, particularly in Thailand, Malaysia, Indonesia, the Philippines and Korea, from which lessons and recommendations for Vietnam to deal with upcoming financial crises are withdrawn.

A CLOSER LOOK TO SOUTHEAST ASIAN FINANCIAL CRISIS

IN 1997 AND THE LESSONS FOR VIETNAM

International Finance Essay

Lecturer: PhD Mai Thu Hien Students:

Tạ Đình Việt Anh – 1214150010 Nguyễn Hải Anh – 1212150008 Chu Minh Lan – 1217150068 Nguyễn Khánh Linh – 1217150070

FOREIGN TRADE UNIVERSITY FACULTY OF FINANCE AND BANKING

TABLE OF CONTENTS

INTRODUCTION 3

I A closer look to Southeast Asian financial and currency crisis in 1997 5

1 Causes of the crisis 5

1.1 Subjective causes 5

1.2 Objective causes 9

2 Developments of the crisis in certain countries 12

2.1 Thailand 12

2.2 Korea 14

2.3 Malaysia 17

2.4 Indonesia 19

2.5 Philippines 21

2.6 Hong Kong 21

3 The effects of the crisis 22

3.1 Negative effects 22

3.2 Positive effects 23

4 Solutions to extricate form Southeast Asian financial and currency crisis 24

4.1 International level 24

4.2 Regional level 25

II The lessons learned from the financial and currency crisis in Asia 28

1 Capital flows regulation tools 28

2 The need to develop appropriate legal frameworks 28

3 The risk of excess capital 29

III The lessons learned for Vietnam from the financial and currency crisis of Asia 30

CONCLUSION 33

REFERENCES 34

After years of economic stability, various Southeast Asian countries experienced theircurrencies under pressure in 1997 as an effect of the appreciation of the dollar against theYen A number of Southeast Asian countries had maintained a currency peg against the USdollar and experienced a deteriorating current account position as well as an increasingforeign debt burden in the process (Dornbusch, 1998) To almost all observers, thesedevelopments came as a surprise

The 1997 crisis was largely unexpected Warnings of fragile financial systems in theregion seem to have been few and appeared at a time when the crisis had almost beenunder way already Therefore, The East Asian financial crisis is remarkable in severalways The crisis hit the most rapidly growing economies in the world and prompted thelargest financial bailouts in history It is the sharpest financial crisis to hit thedeveloping world since the 1982 debt crisis It is the least anticipated financial crisis inyears (Radelet and Sachs, 1998) Few observers gave much chance in early 1997 thatEast Asian growth would suddenly collapse The crisis has also raised serious doubtsabout the International Monetary Fund’s (IMF’s) approach to managing financialdisturbances originating in private financial markets

From the aforementioned features, the purpose of our paper “A closer look to Southeast

Asian financial crisis in 1997 and the lessons for Vietnam” is to analyze the causes and

consequences of the East Asian financial and currency crisis with the view to discoveringwhether intrinsic instabilities in the international capital markets helped either set it inmotion or deepen the crisis, particularly in Thailand, Malaysia, Indonesia, the Philippinesand Korea, from which lessons and recommendations for Vietnam to deal with upcomingfinancial crises are withdrawn

The structure of our research is divided into two main parts The first part focuses on thecauses, occurring and consequences of the East Asian crisis on several Southeast Asiancountries including Thailand Malaysia, Indonesia, Philippines along with Korea and Hong

Kong This part also analyses the solution to escape from this financial crisis of suchcountries The second part of our paper draws lessons learnt from this crisis so thatcountries may have appropriate methods to prevent and handle similar crises in the future.

We also suggest several recommendations for Vietnam from this crisis to better thefinancial market and risk management in the last part of our paper

I A closer look to Southeast Asian financial and currency crisis in 1997

1 Causes of the crisis

1.1 Subjective causes

1.1.1 Week macroeconomic foundation and imbalanced economic growth

Assessing the developing level, though different, but overall Thailand and some SoutheastAsian countries’ economies saw an overheating economic growth at the average rate of7.5-8% in the previous years which latently signaled the imbalances leading to thefinancial crisis

First of all, the inner imbalance was exposed through the contradiction of the rapid growthrate to put upward pressure on prices due to the growing cost of production and business.Thailand's consumer price index rose rapidly, reaching 5.6% in 1996 compared to 3.4% in

1993 The government must, therefore, increase the minimum wage to the average of8.5%/ year; meanwhile, labor productivity increased on average of only 3%.(Jungjaturapit, 2008) This feature happened similarly in Malaysia, Indonesia andPhilippines On the other hand these countries had to raise foreign loans to compensate forthe domestic shortage in order to speed up the modernization of production and increasethe investment in infrastructure

1.1.2 Deficit in current account

Except for Indonesia who partly relied on oil export, Thailand and Malaysia both fell intodeficit of current accounts at an alarming rate According to analysis of the IMF, if thedeficit was above 5% of GDP, the country would be pushed into recession Currentaccount deficit also implied that Southeast Asian economy had been seriously imbalanced.From 1995 onwards, deficit of current account in Thailand was 8.1% and 8.2% of GDP in

1995 and 1996 respectively Similarly in Malaysia, the deficit was 9.7% of GDP in 1996.This is the deficit level at which Mexico encountered when crises exploded in 1994.Meanwhile the deficit was of 4% GDP in Indonesia and 3.2 % GDP in Philippines in 1996(Eichengreen, 1998)

The main reason causing the situation of current account deficit was that the sharp decline

in exports of such countries from 1995 which severely worsened the deficit of currentaccount and balance of payments deficit had forced these countries to borrow short-termloans abroad to offset domestic expenditures

1.1.3 The flow of foreign investment

Loose monetary policies and financial liberalization in the US, Europe and Japan in thelate 1980s led to an excessively high global liquidity situation Investors in theaforementioned monetary center of the world sought to change their asset portfolio bytransferring capital abroad Meanwhile, Asian countries had implemented policies ofcapital account liberalization Interest rates in such Asian countries were higher than indeveloped countries Therefore, international capital flows were flowing massively intoAsian countries

In addition, the promotions of investment and implicit protection of the government forfinancial institutions also contributed to the situation where Asian companies borrowedmoney from bank regardless of risks in the while commercial banks also borrowed foreignloans regardless of even higher risks, but mostly short-term debt and non-insurance debt.(The phenomenon of asymmetric information leads to adverse selection and moral hazard.)(Stephany and Stephan, 1999)

Table 1 – Foreign loans (in percentage of GDP)

1.1.4 Reluctantly-retained foreign exchange rate

If the above issues are the root causes of the crisis then the policies of "pegging" among

cause leading to the serial devaluation of these regional currencies Despite the onset offloating of the Thai baht leading to the spillovers effect onto the Philippines Peso,Malaysia Ringgit and Indonesia Rupiah, in fact in some extent, the local currency hadalready been depreciated confronting the increasing trend of the dollar (Lionel, 2014).

In theory, the fixed exchange rate regime under the Bretton Woods system, had positiveimplications on the stabilization of local currency flow and support economic growth.However, if overusing a fixed exchange rate in the context that local currency had beendropped against other strong currencies as well as economic structure was imbalanced itmight lead the economy to a greater risk of crisis

Back to 1996 when the symptoms of the current account deficit had just appeared,Thailand and other Southeast Asian countries should have implemented the policies tofloat the domestic currency to return them to their real value, in combination withtightening fiscal policies, the risk of crisis might have undoubtedly been stamped out Butinstead, the governments of Southeast Asian countries imposed artificially managedforeign exchange rate policies to retain their value so as to attract foreign investment tocover the hole of the current account and inflation

Thailand and some Southeast Asian countries had fallen into the Impossible Trinity ineconomy They had pegged their domestic currencies value to the US Dollar and at thesame time allowed the free flow of capital (capital account liberalization) The rapidgrowth of Southeast Asian economies in the 1980s and the first half of the 1990s hadcreated pressure on increasing value of domestic currency To defend the fixed exchangerate, the central banks in Southeast Asia had implemented loose monetary policies Theresult of such actions was an upward pressure on inflation due to the increase in moneysupply Sterilization policy was then imposed to ease the inflation, however, it alsopromoted the capital inflows into these countries’ economies

In the mid-1990s, South Korea had a relatively stable macroeconomic foundation exceptone issue that the Korean Won’s value constantly rose with the US Dollar’s in the period

after 1987 This was the main cause of the weakening in South Korea’s current account asprices of Korean export commodities on international markets increased In this context,Korea had pursued a loose pegged exchange rate regime and capital account liberalization(Kim, 2006) Thus, the current account deficit was offset by foreign borrowings of Koreanbanks that were mostly short-term debts and non-insurance debts.

1.1.5 A weak financial system and loss of confidence issue

The most costly lesson for each country’s economy was that if they only paid attention totemporary growth without consolidating the whole financial system, the inevitableconsequence would be the deficit of state budget, increasing inflation, and sooner or laterthe economy would fall into crisis Bank financial system is a very sensitive and riskyfield, in which just an injury could cause a major disturbance in the process of economicregulation Too long maintaining of fixed exchange rate had created gaps in the bankingsystems of these countries The result of weak banking system was the operationalloopholes through which currency speculators took advantage to buy foreign currencyloans for profit The appreciation of the Japanese Yen against the US Dollar encouragedcommercial banks rush to buy the Yen and then resell them to buy US Dollar to earn theexchange difference

The phenomenon of capital loss due to currency speculation had become increasinglyserious In order to sustain the growth and fixed exchange rate, commercial bankscontinued to borrow money from foreign banks which led to a dangerous limit where thedebt ratio far exceeded the foreign currency reserves IMF experts said the debt ratio /foreign exchange reserves in Thailand, Indonesia were approximately 3 times, inPhilippines was 4 times, and especially Malaysia's foreign currency reserve was at thelowest of 10 billion USD (Pablo, 2000) It was even more dangerous when foreigninvestors withdrew their investment capital urgently, seeing the instability of the regionaleconomies

Due to capital losses and non-performing real estate market, a mass of commercial banks

in the region had gone insolvent Typically in Thailand, the ten largest banks were on theverge of bankruptcy Domestic and foreign investors began losing their faith which led tothe syndrome where a series of capital withdrawal from banks happened had underminedthe stock market in these countries

After the resignation statement of the Minister of Finance at the end of June, 1997 A.Vinavan when the crisis occurred, the business investors’ loss of confidence madeBangkok stock markets fall to the lowest level with only 482.97 points, declined 14.75points from the middle of such month (Pablo, 2000) The speculators dumped their stocksand transferred money abroad to buy US dollars

In 1996, the international semiconductor market fell into a sharp recession; therefore, theirprices fell more than 80% IC The Japanese and Southeast Asian Newly IndustrializedCountries (NICs)’s electronic products’ sales fell more than 40% on the world market Onthe other hand, the attractiveness of the Southeast Asia market towards the US andWestern European partners were declining comparing to the Chinese, Eastern Europeanand the US Latin market Japan was also in confusion about the large loan contract to thenegative fluctation of the financial market area As reported by D.M Green Fell Banks,more than half of Thailand's 70 billion USD banks’ debt was from Japan and mainly washot borrowing Thus, when interest rates rose, not only the cost of borrowing increased but

the capital flow into Thailand would also be reduced or reversed and led to a liquiditycrisis in Thailand and also pressured the Philippines Peso and Indonesia Rupiah.

Japan, one of the largest export market of Asian countries, had been stagnant since theearly 1990s The Chinese Yuan had been undervalued compared to the US Dollar since

1994 along with many other factors made the export products from China cheaper than thesame types of export products in Southeast Asia Meanwhile, the US economy wasrecovering after the recession in the early 1990s and US Federal Reserve System under theleadership of Alan Greenspan began to raise US interest rates up to curb the inflation Thisaction made the US market become a more attractive investment market than those in EastAsia, and therefore attracted lots of short-term capital flows through higher short-terminterest rates and US Dollar’s appreciation And because the Southeast Asia currencieswere pegged to the US Dollar, the export of such countries became less competitive Fromthe spring of 1996, growth in Southeast Asia's exports dropped quickly, weakening theircurrent account

1.2.2 Simultaneous speculative attacks and capital withdrawals

The direct cause of the East Asian financial crisis in 1997 was the simultaneousspeculative attacks and capital withdrawals from Asian countries When detecting signs ofdeterioration of financial-banking system of the region, many foreign speculators hadintensified their monetary speculations Many speculators, in total of 2300 private creditfunds in the US whose assets were worth of more than 100 billion USD had jumped intothe regional market in July and August, 1997 Apart from funds controlled by Soros, therewere other credit funds like Tiger, Orbis, PUMAR, Panther and Jaguar They bought theThai Baht then Philippines Peso, Malaysian Ringgit, Indonesian Rupiah and evenSingaporean Dollar at the estimated total of 10 to15 billion US dollars for speculations(Giancarlo et al, 1998) Moreover, the central banks’ foreign exchange reserves depletedmade speculative attacks even longer

The consequences were eventually exposed Real estate market in Thailand collapsed.Some financial institutions went bankrupt People no longer believed the governmentscould afford to maintain their fixed exchange rates When detected the serious weakness inthe economies of Asian countries, some macro hedge institution conducted currency attack

to Asian countries Foreign investors withdrew their capital simultaneously

Foreign Minister of ten ASEAN countries at the time believed that a tight linkage ofmonetary system was a careful attempt to consolidate the ASEAN economies The 30th

ASEAN Foreign Ministers Meeting took place in Subang Jaya, Malaysia adopted a jointstatement on July 25, 1997 stating deep concern and calling on ASEAN countries tocooperate more closely in order to protect and enhance the interests of ASEAN in thisperiod Incidentally on the same day, the Central Bank of the most affected countries bythis crisis met in Shanghai in the Executives' Meeting of East Asia and Pacific CentralBanks (EMEAP), and failed to give a measure for a new lending arrangement A yearearlier, the Finance Ministers of these countries also attended the 3rd Asia-PacificEconomic Cooperation (APEC) in Kyoto, Japan on March 17, 1996, and according to ajoint statement, the parties could not double financial funds serviced for GeneralAgreement on Loan and Mechanisms (Giancarlo et al, 1998)

Finance was in emergent situation Therefore, the crisis could be viewed as a failure tobuild an adequate capacity in time and to prevent the currency attacks Some economistscriticized the tightened financial policies which IMF applied in such countries in the crisisworsened the crisis itself (Khor, 1999)

2 Developments of the crisis in certain countries

2.1 Thailand

From 1985 to 1995, Thailand's economy grew at an average annual rate of 9% During theyears 1991- 1996, the trade balance of Thailand has always been in deficit, a total of 35.26billion USD The current account deficit in 1996 was 14.7 billion USD To offset the tradedeficit and for investment, Thailand had foreign debt and by 1996 the debt has increased to

89 billion USD This debt was used both to increase national reserves, which increasedfrom 18.4 billion USD in 1991 to 38.7 billion USD in 1996, financial investments andshort-term credit accounted for 90% of total investment annual overseas Short-term debt

in 1995 was nearly 1.18 times the foreign exchange reserves of the country Thailand haslost the ability to pay foreign debt payments since 1995

Since the beginning of 1997 to March 1997, residents and investors started withdrawingtheir capital in the form of money out of the banks and financial companies, forcing thegovernment to close down the stock market on March, 3rd 1997 and required all financialinstitutions to increase cash reserves and announced 10 financial companies active in

removing abnormal condition (Unico Housing Co.Ltd, Themes- Fuji, Royal International,Sri Dhana, etc.)

On March 4th and 5th 1997, over 21.4 billion baht was withdrawn from banks and financecompanies On May 14th and 15th 1997, the Thai baht was attacked large-scalespeculation In 13 years, the Thai baht exchange rate anchored with 1 USD / 25 Baht OnJune 25th 1997, the Government announced the closure of 16 finance companies, raisingthe total number of bankrupt finance companies up to 58/91 (64%) nationally The Thaigovernment had to sell foreign currency, as foreign reserves fell sharply from 38.78 billionUSD in June 1996 to 31.4 billion USD on June 30th 1997 June 30, Prime MinisterChavalit Yongchaiyudh said they would not devalue the baht, but eventually re-floated thebaht on July 2 Baht immediately devalued by nearly 50% In January 1998, it was down to

56 baht rate for 1 USD Stock market index has dropped from 1.280 in 1995 to 372 in theend of 1997 At the same time, market capitalization decreased from 141.5 billion USD ofcapital to 23.5 billion USD Finance One, the largest financial companies in Thailand wasbankrupt

On August 11th, IMF announced that it would provide an aid package worth 16 billion USdollars for Thailand On August 20th, IMF adopted another rescue package worth 3.9billion USD to ask the Thai government to raise taxes, cut public spending, privatization ofsome enterprises under state ownership and increased interest rates In December 1997, thegovernment has closed 56 financial institutions, laid off 16,000 people

Direct results of the financial and economic crisis in Thailand were:

- Banks and financial companies continuously went bankrupt, national economic recession.Economic growth of 6.7% in 1996 dropped to -0.4% in 1997, -8.3% in 1998 and 1% in1999

- Nearly 2 million workers lost their jobs and income

- Foreign investors lost confidence, pulled out of the country, worsening investmentclimate In 1995, 1996, each year about 20 billion USD were poured into the Thai capital,

but in 1997, 15.8 billion USD was withdrawn from the country, in 1998, 9.5 billion USD

of capital went overseas

Economic turmoil, people lose faith inevitably shaken the political system Four monthsafter floating the baht, Thailand's prime minister resigned

In the process of the crisis, after floating the baht, the exchange rate has been increasing,from January1998 to July 1997 and reached 53 baht/USD, with 212% in June 1997 Onlythis time, January 1998, the government formally committed to pay all the debts ofcommercial banks, including foreign, the new foreign exchange rate decreases

Thailand Baht/USD

Philiippines Peso/USD

Malaysia Ringgit/

USD

Indonesia Rupiah/

USD

Korea Won/USD

"untrusted" relegation On September 30th, exchange rate reached 914.8 won/USD, anincrease of 8% compared with 833.2% on December 31st 1996 On October 28th and 29th

1997, the foreign exchange rate hit allowed fluctuation, no one sold foreign currency to

At the time the crisis broke out in Thailand, South Korea had a giant foreign debt burden.The companies owed domestic banks, domestic banks still owed foreign banks Some ofthe defaults occurred When the Asian market crisis happened, investors began sellingKorean stocks at a large scale November 28th, 1997, the credit rating agencies Moody'slowered the rating of Korea from A1 to A3, then on December 11th back down to B2 Thiscontributed to the stock price of Korea more discounts Particularly on November 7th, theSeoul stock market dropped 4% November 24th slipped 7.2% due to psychological fear ofIMF would require South Korea to adopt austerity policies Meanwhile, the won droppedthe price to about 1700 Won/USD from 1000 Won/USD From May 6 to 12/1997, theGovernment had to sell $ 14 billion to retaining the peg, but had to abandon the effortwhen foreign currency reserves fell from 34.1 billion USD to 20.4 billion USD OnDecember 14th 1997, the won was floated On December 23rd, the price soared to 2,000Won/USD, equal to 237% compared with December 31st 1996 The final contracts havefloating Won was due to reduced foreign currency loans from abroad and the withdrawal

of foreign investment in South Korea out of the country in 1997 On December 29th 1997,

10 of the 14 commercial banks had been closed Two major commercial banks were undergovernment management At the end of April 1998, healthy plan four commercial bankswere denied, many banks were closed On June 29th 1997, the Government ordered theclosure of five small banks and two other banks were merged On August 28th 1998, twolargest Korean banks which were commercial banks, Korea and Hanil Bank announcedthat they would merge On September 25th 1998, the Government announced anotherround of restructuring the banks Total government funding 64 billion won to banks In

1997, 14,000 enterprises were bankrupt and in 1998, there were 53,000 businessbankruptcy

The bankruptcy of more than 70,000 businesses and banks in 1997 and 1998 gave thenumber of unemployed rose from 426,000 in 1996 to 1.461 million in 1998.Unemployment, loss of income on a large scale raises a series Social Issues The number

of drug addicts increased from 6819 people in 1996 to 10,589 people in 1998 The number

rose from 80,000 divorces in 1996 to 123 700 in 1998 In order to overcome theconsequences of unemployment, the Government has expanded insurance system forbusinesses with 5 employees or more, compared with pre-crisis for enterprises with 30employees or more The minimum time to be insured was increased from 1 to 2 months,and the minimum wage was increased from insurance pay 50% of the salary beforeunemployment up to 70% A program for low-interest loans for the unemployed will beimplemented from May 4/1998 to help them ensure the life, work or children's, careerchange and tenants The government has also implemented training programs to helpunemployed job change and people do not have to learn a job Within 2 years from 1998 to

1999, the Government spent a total of 10.000 billion won to develop measures to combatunemployment

The rising unemployment rate and requires improving the efficiency of labor to makeproducts more competitive has led to a breakthrough change in the system of recruitmentand salaries of Korea which salary is paid according to time with the company, trainingtime and age of the employees From 1997, businesses started moving book based wagessystem the contributions of workers On May 1st 1999, 15% of enterprises with more than

100 employees have salaries applicable on the new system, and to the end of 1999 over50% of enterprises have adopted Government has many tax incentives for these firms

Economic growth and unemployment in times of crisis

2.3 Malaysia

Shortly after Thailand floated the baht (July 2nd 1997), Malaysian ringgit and KualaLumpur stock market immediately strong downward pressure In just the first 12 days ofJuly 1997, state banks to sell 700 million USD to hold down exchange rates On August24th 1997, Indonesia declared a floating rate Ringgit fell from 3.75 Ringgit/USD to 4.20ringgit/USD Most of the downward pressure on the ringgit from the sale of this currency

on money markets abroad Participants maintain money market accounts in ringgit in statesold more than bought with plans to use devaluation of the ringgit in the future As a result

of Malaysia's domestic interest rates fell to encourage capital flows abroad The amount ofcapital outflow of 24.6 billion ringgit reached in the second quarter and third quarter of

1997

Before the crisis, the current account deficit of 5% of Malaysia Malaysia is the countryreceived more foreign direct investment, this is reflected in the KLSE (Stock Exchange ofMalaysia officially) is considered the exchanges with the most active in the world (totalvalue transactions surpassing even though NYSE market cap is much lower) At thatmoment, everyone expected the country to maintain growth and to become developedcountry by 2020

In the period before the crisis, KLSE Index stands at 1,200, the ringgit was traded at theratio 2.5: 1 USD, the overnight rate below 7% Overnight rates rose from less than 8% to40%, making the credit rating dropped and happen wave of selling the stock and currencymassively

In late 1997, the credit rating fall below the average for the investments are not guaranteed,KLSE lost 50% points, falling below 600, the ringgit also lost 50% of its value, while 3.8 1USD exchange contract In 1998, GDP decreased by 6.2%, 4.7% extra ringgit and KLSEvalue drops below 270 points The crisis has made economic growth declining from 8.2%

in 1996, to 7% in 1997 and -7.5% in 1998 The unemployment rate rose from 2.5% in

1997 to 3.2% in 1998