Preliminary Draft
The East Asian Crisis: Investigating Causes and Policy
Responses
by
Warwick McKibbin
*
and Will Martin
**
*
The Australian National University and the Brookings Institution and
**
The World Bank
September 29, 1998
Abstract
We use a forward looking modeling framework to capture some of the major interactions
between asset markets and trade involved in the East Asian crisis and its aftermath. We
take the primary cause of the crisis to be a fundamental reassessment of the profitability of
investment in the region, and add secondary shocks resulting from the financial
implications of responses to the initial shock. In this way, we can generate time profiles for
the return of the countries of the region to economic health, and consider issues of
contagion and policy response.
1
The East Asian Crisis: Investigating Causes and Policy Responses
†
The East Asian crisis of 1997-8 is different from most of the earlier structural
adjustment crises that have affected developing countries. Unlike the Latin American crisis
of the 1980s, it does not reflect either commodity price shocks or large changes in world
interest rates. Nor does it reflect the fiscal imbalances and inflationary shocks that have
been central to many other crises. It involved large-scale borrowing abroad, but by the
private sector rather than the government, and for the normally well-regarded purpose of
funding capital investment.
Since the early 1990s, the pattern of financial flows between developed and
developing countries has changed significantly, with private flows to developing countries
expanding six-fold between 1990 and 1996 (World Bank 1997). These flows have had an
enormously positive impact on the world economy, facilitating very rapid growth in East
Asia and lifting millions out of poverty. Unfortunately, it is now clear that these financial
flows are more complex to manage than has previously been realized, and new techniques
are needed to deal with the instability with which they can be associated.
Some of the conventional shocks that require structural adjustment can be seen on
economic radar screens. We know, for example, that excessive government spending will
lead to disaster, and can offer suggestions for dealing with the inevitable turbulence when
it hits. Some shocks, such as commodity price shocks, are difficult to see on the economic
radar, but we have well-defined flight rules for dealing with them. The shocks that hit East
Asia are like Clear Air Turbulence—the shocks are invisible and we don’t have good flight
plans for dealing with them.
Given the increasing integration of world capital markets, it seems likely that more
shocks like the ones that hit East Asia lie in store for both developed and developing
countries. It is therefore particularly important that we learn from the current crisis and
use the experience to develop better techniques for identifying and dealing with shocks of
this type.
†
We wish to thank Francis Ng for his excellent assistance with this study.
2
Our first objective in this paper is to identify some of the key shocks that affected
the East Asian crisis countries. We consider shocks that are external to the region, and
those that are internal to the affected countries. Once the initial shocks hit, the situation
changed substantially and there were important responses by both the private sector and
the government. These responses, in turn, had important second-round impacts. We use
the Asia-Pacific G-Cubed model to assess the impacts of both the primary and secondary
shocks on these economies. After forming an assessment of these impacts, we examine
some possible policy responses.
To keep the analysis manageable, we focus on the three most severely affected of
the crisis countries—Thailand, Indonesia and Korea
1
.
Shock Identification
An extensive literature has now emerged on the causes of the East Asian crisis.
While extremely informative, much of this literature focuses on relationships between
endogenous variables, such as domestic interest rates, exchange rates, and current account
imbalances rather than on exogenous shocks that set off or exacerbated the crisis. We first
consider the shocks that could plausibly be regarded as exogenous to the crisis countries,
and only then turn to the responses in policies and by financial institutions that may have
compounded the initial shock. The three main types of primary shocks considered are:
terms of trade shocks; appreciation of the US dollar under a currency peg; and downward
revisions in the anticipated profitability of investment.
A key question in examining a crisis of this nature is whether the crisis was purely
the result of a financial shock such as a bank run or disorderly workout (Radelet and
Sachs 1998), or from a change in economic fundamentals. While the causes of a purely
financial panic are typically difficult to observe, at least some changes in economic
fundamentals can be observed and used to identify potential causes, and hence to focus the
analysis.
1
For an overview of the conditions leading up to the crisis in each of these countries see Warr (1998) on
Thailand, McLeod (1998) on Indonesia and Smith (1998) on Korea.
3
Potential Shocks to Fundamentals
Examination of the data for the affected countries does not reveal major terms of
trade shocks that might plausibly have created a need for structural adjustment in all of the
affected countries (Hoekman and Martin 1998). In Korea there was a substantial fall in the
terms of trade during the lead up to the crisis, a deterioration of 27 percent in the three
years up to late 1997. While this is a large decline, it seems likely to have been due in large
part to improvements in the production technology for goods such as semiconductors. If
we were able to make adequate adjustments for these improvements in technology, it
seems likely that the adverse impact of this deterioration in the terms of trade would be
substantially smaller than would be suggested by the raw terms of trade numbers. In
Indonesia, the terms of trade appear to have deteriorated in 1994, but appeared to recover
by early 1997, and only fell substantially below trend in the third quarter of 1997,
following the onset of the crisis.
Figure 1. Terms of trade changes in the three crisis countries.
Terms of Trade Changes
0.00
20.00
40.00
60.00
80.00
100.00
120.00
1992Q1 1992Q3 1993Q1 1993Q3 1994Q1 1994Q3 1995Q1 1995Q3 1996Q1 1996Q3 1997Q1 1997Q3
Korea
Indonesia
Thailand
Sources: South Korea (International Financial Statistics); Indonesia (Bank Indonesia); Thailand (Bank of Thailand).
4
Another external shock that has been widely viewed as a potential contributing
factor to the crisis was the major shift in the yen/dollar exchange rate since 1995. The
depreciation of the yen has greatly increased the competitiveness of Japanese exports, and
raised the cost within Japan of imports from the East Asian developing countries. Given
the pattern of export similarities, this shock might have been expected to have a
disproportionately large impact on Korea, which competes with Japan in a range of
manufactured goods. The depreciation of the yen was also associated with a large
expansion in Japan’s trade surplus that might have compounded the impact on the East
Asian countries. However, if the change in the yen dollar exchange rate were large enough
to be the primary cause of the shock, then one would generally expect it to have had a
major adverse impact on the terms of trade of the affected countries.
The de facto pegging of the exchange rates of these countries to the US dollar has
widely been viewed as a source of adjustment pressures and a catalyst for the crash. A
useful framework for assessing the potential importance of a pegged exchange rate is
provided by Montiel (1997). This consists of decomposing the nominal effective exchange
rate into a component due to movements of the country’s currency against the reference
currency (in this case the US dollar), and a second component measuring changes in the
value of the dollar against the currencies of the country’s trading partners
2
. The CPI for
each country was used as the price indicator for that country. The two components of
exchange rate changes are written as local currency per US$ (XRI) and US$ per unit of
trading partner currency (ERI). Thus, a fall in either index is an appreciation. In decline in
ERI would indicate an appreciation of the dollar against the currencies of the country’s
main trading partners and, hence, a potential competitiveness problem.
The results of this decomposition are presented for Thailand in Figure 2 for the
period from 1990 to June 1997, immediately prior to the onset of the crisis.
2
The calculations were done using the trade weights for the largest 20 trading partners in 1995 and follow
the methodology set out in Appendix A.
