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Assessing the Recent Asian Economic Crises: The Role of Virtuous and Vicious Cycles.

Asia, the economic miracle of the Last half of the twentieth century and the world's highest growth region, experienced a set of serious interrelated economic crises in mid-1997. These Asian crises expanded in 1998 and also had a significant negative influence on economic growth and financial confidence worldwide. These crises seemed to appear suddenly given that up until recently, the affected Asian countries were being widely cited as outstanding models of economic growth. Foreign capital was flowing into these Asian countries at an annual rate of about $100 billion in 1996, while it was flowing out at about the same rate in the second half of 1997. Expectations of economic growth over the next few years were slashed not only for these Asian countries, but also for many other countries and for the world economy. In many Asian countries, economic suffering resulted in political unrest and riots with loss of life. In the first half of 1998, whereas some Asian economies had recovered somewhat from this asset price, currency, and economic and political carnage of late 1997, some countries like Indonesia were still in terrible shape.

How did this unexpected turn of events come about? What are the basic causes and determinants of this Asian economic malaise? More importantly, what are the lessons that can be drawn from these crises? Finally, what are the prospects of an economic turn-around in the Asian and global economies?

An examination of the Asian economic problems that became apparent in late 1997, finds that the suffering Asian countries share many characteristics. Many of these countries have highly developed industrial economies but relatively poorly developed financial markets and institutions. Because of such imbalances, these Asian economies suffered not only from asset bubbles that became unsustainable, but also from banking crises that continue to hamper economic recovery. Further, many economic policies with positive feedback characteristics (virtuous cycles) that were used to accelerate economic growth in the Asian countries, contributed to and worsened the 1997-98 economic downturn. Indeed, these positive feedback economic and financial cycles that were virtuous during economic growth, turned into vicious cycles during the downturn. Thus, sound economic recovery in the Asian economies will require structural reform and the development of better and more robust domestic financial systems.


Three aspects of the late 1990s Asian economic crises make it especially significant and interesting. First, the crises seemed to have come upon us suddenly in mid-1997 and even the major debt rating agencies seemed to have been caught off-guard. Second, the speed with which the crises escalated, from dropping currency values and asset price crashes to declining economic growth rates, also seemed surprisingly rapid. Third, these Asian economic crises seemed to have had a disproportional negative impact on other developed and developing economies.

Depth and Range of the Asian Crises

The 1997-98 economic crises in Asia are well documented not only in the press, but also in a number of studies (e.g., Goldstein, 1998; Henderson, 1998; and Noland et al., 1998). The Asian crises seemingly started with a summer 1997 fall in the Thailand Baht that quickly spread to weaknesses in other Southeast Asian currencies especially after Taiwan devalued its currency in October 1997. In the second half of 1997, the Indonesian exchange rate fell by over three fourths, the Thai Baht and the Korean Won had lost half, and the Philippines Peso and the Malaysian Ringgit lost over 40% of their international values. Markets for financial assets and real estate in these countries also declined by similar amounts in local currency terms and by even larger amounts in U.S. dollars (e.g., over eighty percent decline in stock values in Indonesia, Malaysia, and Thailand). Even fundamentally strong Asian economies were affected. For example, between July 1997 and April 1998, Hong Kong suffered drops of between 30 and 40 % in real estate and stock prices, eliminating wealth equivalent to 2 years of its Gross Domestic Product (GDP).

As in Japan in 1990, financial market bubbles burst in many other Asian countries in 1997. In addition, overbuilt property markets and overextended banks in Asian countries also presented additional bubbles that burst in 1997 making these economies even more vulnerable to recessions (e.g., Walker, 1998). It was widely feared that this Asian crises could spiral from a regional recession into an economic depression with serious consequences for the rest of the world.

In fact the 1997 Asian crises were very significantly negative not just for some of the fastest growing countries of the region, they also had a significant negative global impact. The Asian economic crises were conveniently blamed for earnings disappointments among U.S. companies with significant (or even insignificant) Asian business and for much of the 1997 and 1998 instability in U.S. financial markets (Asian economic uncertainties were a major factor in the late 1998 lowering of interest rates in the U.S.).

International Responses to the Asian Crises

To prevent continuing declines in the rapidly deteriorating Asian economies and to limit the global spread of this economic downturn, teams from the International Monetary Fund (IMF) and the United States Treasury Department (USTD) were sent to the region in late 1997 and early 1998 with offers of financial aid that were packaged with requirements for economic reform. The 1997 and 1998 international rescue programs (totaling over $118 billion) succeeded in temporarily restoring confidence and in reducing the further spread of default among Asian countries. Although, this IMF led rescue reduced the losses suffered by the Japanese, German, and U.S. banks that had made high risk, high margin, loans to Asian countries, it worsened the moral hazard problem in international banking and increased the likelihood of future imprudent bank lending sprees (like those in Latin America in the 1980s and in Asia in the 1990s).

Even though international rescue efforts may have limited the immediate damage, IMF policies in Asia came under widespread criticism. By insisting on high interest rates and restrictive monetary policies in the affected Asian countries, IME policies punished many good companies in these countries (along with the many banks and companies that had indeed made poor business decisions). Although such restrictive policies may have been appropriate in the Latin American crises of the 1980s, they seemed much less suitable for the Asian crises in the 1990s especially as these Asian economies did not share the weaknesses of the Latin American economies of the 1980s. Indeed, the IMF-led Asian rescue plans came under much criticism, with many contending that IMF restrictions especially in the early part of the Asian crises led to a deepening of the crises, unnecessary suffering, and delays in Asian economic recovery.

As many of the Asian economies continued to deteriorate, the IMF seemed to adjust its policy prescriptions and change course in a number of those Asian economies, and recommendations and plans for fiscal deficits moved from about 1% of GDP in February 1998 to 5% and 8.5% of GDP for South Korea and Indonesia respectively in November 1998 (Moreno, 1998). It has been noted that the restrictive IMF response to the Asian crises was in sharp contrast to the expansive response of the U.S. Federal Reserve to a similar crisis of confidence in the U.S. financial markets in late 1998. Does this mixed assessment of IMF policies depend on assumptions about the nature and determinants of the Asian crises? Why were strong economies outside Asia vulnerable to this Asian 'flu'?


The 1997 Asian crises seemed to have been caused by a confluence of international forces and domestic financial weaknesses. Indeed, the currency crises were only symptoms while the underlying causes of the economic crises were more structural. Global economic integration and the rapid emergence of newly developing countries as international competitors posed difficult challenges for the export driven Asian economies in the 1990s. However, many Asian countries faced these external challenges with domestic financial systems that were inadequate and highly under-developed; a combination that led to the 1997 crises in Asia. For much of the last half century, driven by growth enhancing savings-investments virtuous cycles, Asian financial systems consisted mainly of government directed financial flows delivered to strategic industries through banks and other financial institutions. Consequently, private Asian financial markets, especially debt markets, did not develop adequately. Thus, Asian financial systems were ill-prepared for the significant increases in private international capital flows in the 1990s.

Changing Competitive Structure and Positive Feedback Cycles

Evolving Global Competition and Currency Pegs

With advances in technology and global communications, the speed at which technology flows across borders has accelerated in recent decades. As a result, in the 1980s and 1990s, the rapidly growing heavily export dependent Asian countries faced increasing competition at the top from mature and advanced countries like Japan and at the bottom from emerging economies like China and India. Thus, each of the Asian countries suffering in this crises had been facing increasing competition simultaneously from economies at lower technological levels that offer lower cost manufacturing bases, and from economies at higher technological levels with reputations for higher quality, greater reliability, and long-time customer relationships. For example, as the low cost producers with educated work forces, China and India have been taking over rising amounts of the low end manufacturing business from many Asian countries, forcing these countries to upgrade their technological capabilities rapidly (e.g., Drysdale and Huang, 1997).

With the emergence especially of China as a global economic power with rising exports in the early 1990s and the extended Japanese recession of the 1990s forcing it to export more, each Asian country had to jockey and adjust to a new and more competitive international environment. These competitive pressures from China and Japan on other Asian countries were accentuated by the devaluation of the Chinese currency in 1994 and the decline of the Japanese Yen after April 1995 when it was 80 yen per dollar. Consequently, many of the other rapidly growing Asian countries that used to have current account surpluses started reporting current account deficits in the 1990s as a result of this tougher competitive environment. Thus, while the Asian currency and economic crises may have been a surprise to the rating agencies, clear signs of trouble were evident even in the early 1990s.

As could have been expected, the countries that seem to have suffered the most had pegged (semi-fixed) exchange rates with few restrictions on cross-border capital flows. Although such arrangements helped attract large amounts of external capital, they also did not allow these countries to easily adjust to forces of supply and demand in the currency markets when these countries started suffering significant current account deficits (e.g., Sender, 1998). These current account deficits put increasing downward pressures on their currencies and led to continued borrowing of ever larger amounts from international lenders, even though these loans were increasingly short-term in nature. Such a process clearly could not continue for too long as a country's debt capacity is limited by its export earnings and other sources of foreign income. The ever increasing overhang of short-term foreign debt would be (and was) disastrous for the value of a currency when foreign lending eventually stops and reverses (as it must). Many of the Asian countries that suffered significant declines in currency values in 1997 reflected just such a situation. Further, many of these Asian countries also could not manage the domestic consequences of these large external financial inflows because of poorly developed and fragile domestic financial markets.

Government Role in Late Industrialization

Rapid economic growth in East and Southeast Asia has been attributed to many factors including demographics (young and expanding workforces), relatively small disparities in income distribution, high savings and capital investment ratios, late industrialization and reverse engineering, Asian values of thrift, hard work, and education, and an openness to international trade and investment (e.g., Krueger, 1990; Krugman, 1994; Wee & Tan, 1997). Although these late industrializing Asian countries nominally had market based economies, economic growth was directed by heavy government influence on domestic competitive policy and financial flows (e.g., Aggarwal & Agmon, 1990; Ranis, 1993). More importantly, it seems that despite some differences, most of these fast growing Asian countries also shared two important characteristics: 1) the use of virtuous economic cycles; and 2) underdeveloped private sector financial systems with heavy government direction of financial flows (e.g., Aggarwal, 1999b). Although these two characteristics may have been the bases of much of the rapid economic growth in the region, these features were also some of the primary contributors to the Asian crises of the 1990s.

Growth-Enhancing Savings-Investments Cycles

Virtuous economic cycles have been used to accelerate economic growth in much of Asia (e.g., Aggarwal, 1996). As an example of such a cycle, consider the positive feedback effects between wages, savings, and capital investments. With high savings rates, a country can have a high rate of investment in productivity enhancing new capital equipment. Such investments can lead to even higher wages and bonuses that can mean even higher savings rates. This virtuous cycle can be an important factor in economic growth especially if the government encourages this process with appropriate policies. In these late industrializing Asian countries, since the 1950s, governments have directed financial flows to selected industries. The risks inherent in such government direction of funds were reduced by the fact that the selected industries were already developed in other countries and could be studied by appropriate government bureaucrats. Although these mutually reinforcing virtuous cycles between savings and capital invest ment succeeded in raising economic growth rates in many Asian countries, they also had some unintended negative effects during a slowdown.

Positive Feedbacks and Collateralized Relationship Lending

When bank lending is based more on collateral and less on credit analysis of the borrowers earning ability, rising asset prices lead to increased borrowing capacity. Further, if funds based on this increased borrowing capacity are widely used to buy more assets that can also be used as collateral, prices of such assets are likely to go up as a result of increased lending. Such asset price increases start the cycle again and asset prices go up in a bubble (that will eventually burst). If asset prices decline in such a system, the positive feedback effects between prices and collateral works in reverse and accelerates the decline in asset prices. As asset prices decline, banks, and other lenders face insolvency as asset-based loans lose collateral and go into default. The resulting banking crises further slows the economy as banks are either reluctant or are unable to lend. Indeed, the banking systems in the affected Asian countries now have non-performing loans that are estimated to be between 30 and 40% of n ational GDPs whereas Japan's non-performing loans are estimated to be as much as a trillion dollars and over 30% of its GDP (e.g., Wolf, 1998).

Underdeveloped Domestic Private Financial Systems

Government direction of financial flows especially over a prolonged period means that private sector financial systems tend not to develop very much. In such countries, financial intermediation generally takes place mainly through institutions that can be influenced heavily by governments and financial markets for corporate securities are not likely to develop much. Bank lending is likely to be based on government direction, political connections, and on the use of collateral.

In part because of the government's certification role, companies are likely to have high debt ratios, low disclosure levels, light monitoring by outsiders, and are likely to mis-allocate capital. In general, feedback from market processes is likely to be weak and distorted as private financial markets are likely to be highly under-developed. But as the gap between an economy and advanced industrial economies becomes smaller and the economy becomes more open to foreign trade and investment, government ability to direct capital successfully seems to decline. Such developments in a country that has relied on government direction, leave a country with poorly developed private sector financial systems vulnerable to asset bubbles and other positive feedback cycle-based instabilities.

Positive Feedbacks and Stability

The stability of a given system depends on the balance between positive versus negative feedback cycles. Negative feedback cycles enhance stability as they dampen the effects of any disturbance and, thus, are important influences in economic equilibrium and system stasis (e.g., higher prices lead to lower demand, a higher body temperature leads to increased use of cooling mechanisms). Positive feedbacks reinforce and magnify disturbances to a system and can lead to instability unless checked by some negative feedback mechanism (e.g., Jervis, 1998). Positive feedback effects in economics are becoming more important with the rise and increasing recognition of network economics, path dependence, and other increasing returns economic phenomena (Arthur, 1989; Heal, 1999). Such positive feedback phenomena were an important aspect of the Asian economic crises.

Positive feedback mechanisms can be the basis of virtuous cycles when they reinforce growth, but the same mechanisms can become vicious when they enhance and reinforce declines. As the above discussion indicates, the institutional conditions that are the bases of virtuous positive feedback cycles can also be the bases of positive feedback based vicious cycles. Indeed, a number of different positive feedback vicious cycles can reinforce each other. As per the June 1998 Annual Report of the Basel, Switzerland, based Bank for International Settlements:

"effects of economic slowdowns, asset price collapses, and banking crises tend to be mutually reinforcing as the curtailment of bank credit depresses asset prices and further deepens recessions. This in turn creates additional problems for banks that are forced to retrench still further. The term vicious cycle has been an overworked term, but it describes Asia's crisis too well."

As the preceding discussion indicates, the 1997 economic crises in Asia seem to have been a result of three major factors: 1) external trade and investment imbalances due in part to economic globalization; 2) financial underdevelopment as one of the unintended side effects of the reliance on government directed capital allocation; and 3) continuing reliance on economic growth enhancing positive feedback cycles. Financial sector development did not keep pace with industrial and technological growth in these Asian countries and these Asian countries lacked self correcting market mechanisms that require transparency in business transactions. Consequently, much domestic investment was being made in projects (such as too many urban high rises) that were uneconomic, but were backed by politically well connected domestic investors. Further, overinvestment in uneconomic projects in Asia was accompanied by imprudently high corporate debt ratios.

Further, the institutional conditions underlying the positive feedback virtuous cycles so useful for accelerating economic growth, are also the conditions that make for positive feedback vicious cycles that accelerate economic decline. Under these circumstances, any of the many 'feathers' that threaten investor confidence, like an episode of domestic financial discord or distress, could break the 'camels back' and start the negative chain of events that characterized the Asian crises.

Global Spread of the Asian Economic Flu

As the following discussion indicates, although the spread of the Asian crises can be expected, given the increasing importance of cross-border trade and investment, positive feedback cycles seemed to have played an important role in the intensification and global spread of the Asian economic crises. Multilateral international intervention led by the IMF and other organizations were important in limiting the global spread of possible financial panic originating in Asia.

Trade, Investment, and Cascading Contagion

The 1997-98 Asian crises spread surprisingly rapidly to other parts of the world. The negative impact of the Asian crises threatened currencies and financial markets not only of developing countries in Latin America, Eastern Europe, and Russia, but also of the developed countries of Western Europe and North America. Why do currency and financial market crises and economic downturns spread from one country to another? A number of factors seem to have contributed to the global spread of the Asian economic malaise. An analysis of these factors indicates that more that one negative factor can interact so that the total impact becomes much greater than a simple combination of each of the factors.

Driven by comparative advantage and risk diversification, advances in telecommunications and information technology, and lower tariffs and declining transportation costs, for the last half a century cross-border trade and investment have risen faster than global economic output (e.g., Aggarwal, 1999a). The openness of the U.S. economy (exports and imports as a percent of the economy) has risen steadily from about 6-8% in the early 1970s to about 25-30% in recent years. Most other countries have had similar increases in international openness. It is widely accepted that the growth of the global economy has benefited significantly from rising cross-border trade. Financial markets and cross-border financial transactions have also multiplied and grown exponentially in the last few decades. For example, government foreign exchange reserves now amount only to one or two days of transactions in the foreign exchange markets as daily volumes for such trading now exceed annual volumes in stock markets. Although this increase in economic globalization has contributed significantly to economic prosperity, we now live in a globally integrated economy with much cross-border trade, lending, and investment activities that transmit economic growth and decline across borders.

Further, although international trade has grown rapidly both in absolute terms and as a proportion of economic output for all countries, these proportions have grown especially for the fastest growing Asian countries. In addition, for these Asian countries, an ever increasing proportion of this rising tide of cross-border trade is with other Asian countries. These cross border economic ties are particularly strong in South East Asia as overseas Chinese business families that extend over many countries play significant roles in each economy in the region. Thus, cross-border economic and financial contagion is likely to be particularly strong for Asian countries.

Economic slowdowns in one Asian country leads to lower exports for its trading partner countries, slowing their economies. These slowing economies in turn further reduce the demand for the first country's exports, exerting further downward pressure on that economy, and so forth in a continuing cycle. Thus, economic slowdowns and trade between countries interact with a positive feedback cascading effect that is negative for the economies of a country and it's trading partners. Such cross-border economic contagion is stronger for countries that trade a great deal with each other.

Further, if a country tries to counter-act declining exports with price reductions such as a currency devaluation, its trading partners may do the same to negate its price advantage. Thus, as an economy and the international value of its currency deteriorate, it is no longer a good customer for its neighbor's exports (in fact, because of the declining value of its currency, it is ready, willing, and able to export more to these neighboring countries). These currency, trade, and economic effects interact to reinforce the negative impacts on a country's economic prospects.

Similar arguments can be made regarding the impact of declining cross-border investments and attempts by countries to counter such declines by raising domestic interest rates. Raising domestic interest rates to counter currency declines or foreign investment outflows generally exerts a negative influence on domestic economic activity. Further, each country's overextended banks and companies also face defaults on their loans and investments in these financially distressed neighboring countries. For example, in the early 1990s Japanese banks sharply reduced their overseas investments in response to rising non-performing loans domestically (e.g., Peek & Rosengren, 1998). Similarly, in early January 1998, Peregrine, a once booming Hong Kong based investment bank, filed for bankruptcy primarily due to losses on its Indonesian loans. Earlier, partly due to their overseas defaults, a number of large Korean and Japanese banks and securities firms had also failed as did Yamiachi, the fourth largest Japanese securities firms.

Financial Role of Expectations

In recent decades, the economic role of services and intangibles has increased greatly and an ever higher proportion of consumer spending is now accounted for by these categories. Driven by advances in electronic and other technologies, average consumption is getting lighter and more valuable with declining demand for commodities and undifferentiated products. Reflecting this overall trend, as a proportion of GDP, financial assets have also risen in importance in most countries. However, the value of financial assets is determined by expectations about uncertain future cash flows associated with them. Thus, changes in investor sentiment and expectations have become much more important in recent decades as they influence values of financial assets, assets that are an increasing proportion of national wealth in most countries. Driven partly by external inflows, financial assets such as bank lending as a proportion of GDP increased at particularly rapid rates; rates that were higher than GDP growth in most of t he affected Asian countries in the years preceding the 1997 economic crises.

However, economic downturns, as they generally are, were accompanied in Asia also by declines in the financial, real estate, and currency markets as investors revise downward their expectations. Financial contagion spreads across borders as investors revise their expectations downward regarding the future value of assets in their own country based on events in a neighboring or other country. In particular, declines in business and economic confidence in one country prompt re-examination and likely downward revisions in business and economic prospects in their trading partners. Indeed, financial and economic decline can and does cross borders especially to countries that may already be over-extended and have vulnerable financial systems.

Unfortunately, it seems that negative news about investor confidence are much more contagious than are positive news. Cross-country correlations in asset prices have been documented to rise especially in times of distress. In addition, it seems that because of investor psychology and documented tendency towards herd behavior in financial markets, contagion can be self-reinforcing unless prevented by agents external to the financial markets (such as regulators and central bankers).

As this discussion indicates, because of extensive cross border trade, lending, and investment among countries, financial and economic difficulties in one country have significant potential to 'infect' other countries with which it has such ties. Much of this cross-border contagion is characterized by positive feedback cycles that accentuate declines in trade, investment, and currency values as well as declines in investor expectations that form the bases for valuing financial assets.

In summary, positive feedbacks have played an important role in the Asian economic crises. Many of the positive feedback cycles have been virtuous for the rapidly developing Asian countries. However, these same positive feedback cycles turned from being virtuous to being vicious after the asset bubbles peaked and the downturn started. In market based economies with strong and well-developed domestic private financial markets and systems, market scrutiny and prices provide valuable negative feedbacks that are stabilizing. To protect their companies, many Asian governments followed and promoted policies that limited such negative feedback especially from market forces. Such policies and practices may have worked at an earlier stage of economic development, but with rising technology levels and globalization, the ability of any government to direct an economy have clearly been declining in recent decades. In many Asian countries, as one possible indication of this phenomenon, return on invested capital has been declining.

The literature on the causes of the economic crises in Asia has generally been framed as a debate between fundamental causes and financial panic. For example, the fundamentals school (e.g., Moreno, 1998; Krugman, 1998) argues that the affected Asian economies were fundamentally flawed. In contrast, the panic school (e.g., Mayer, 1998; Radelet & Sachs, 1998) argues that the Asian economies were fundamentally sound but the crisis was caused by financial panic. As the discussion here indicates, the causes of the Asian economic crises seem to be a mixture of the two, i.e., the affected Asian economies depended fundamentally on economic and financial structures that gave too much importance to positive feedback cycles and not enough to market driven stabilizing negative feedbacks. The economic crises in Asia seemed to have been accentuated and spread globally by self-reinforcing changes in financial expectations that were eventually limited by domestic, IMF, and global regulatory action and by offsetting investme nts by global financial markets.


Economic recovery in Asia is likely to be a slow process given the need to reform, restructure, and build robust domestic financial systems. Not all Asian countries will recover at the same rate or in the same way as they differ significantly in terms of economic structure, how the crises affected them, and in their understanding and acceptance of the causes of the crises.

Differing Economic Structures in Asia

Although the Asian countries in the late 1997 crises share many characteristics including high rates of savings, investment, and economic growth, they also differ along many significant dimensions. For example, although Japan is the largest and technologically the lead economy in Asia, it is characterized by an unusually strong group ethos in business and personal life. Its banking and financial systems are shaky and it has been in a prolonged economic slump following the 1990 bursting of its bubble in asset prices.

Next in terms of technological and economic development come the four 'Tiger' economies of Korea, Taiwan, Hong Kong, and Singapore. The Korean economy is dominated by large business groups (Chaebols) who have close connections with the government bureaucracy. In contrast, the Taiwan economy is characterized by numerous small companies many of which are allowed to go bankrupt fairly easily. Although Hong Kong and Singapore are both city states, Hong Kong has very little government influence on the economy, whereas the Singapore economy is characterized by the presence of very large government owned companies.

The next economic tier of countries includes Thailand and Malaysia, then Indonesia and Philippines, followed by Vietnam, China, and India. Each of the countries in this tier differ greatly by size, technological sophistication, cost structure, government influence, openness to foreign trade and investment, and competitiveness of the private sector. It is important to note that these differences are likely to lead to differences in these countries' recovery and growth prospects.

Interestingly, in this crises, China and India, Taiwan, and Singapore have been able to avoid as serious a damage to their currencies and economies as suffered by other Asian countries. These differing vulnerabilities indicate that some countries are more resistant to foreign economic contagion than others. It seems that countries like Singapore and Taiwan avoided excessive debt and asset bubbles, had better financial disclosure, and well-developed procedures allowing unsuccessful businesses to fail. Further, the Asian countries that avoided the worse problems either limited cross-border financial flows by placing restrictions on such flows (e.g., China and India), or had foreign exchange reserves that were high relative to their needs and that were consistent with their exchange rate regime (e.g., Singapore and Taiwan). As the limited success of some Asian countries discussed above indicates, economic recovery in Asian countries depends greatly on increasing the consistency between openness of external acco unts, flexibility of exchange rate regimes, and the robustness of domestic financial markets.

Need for Financial Reforms

To restore long-term economic growth, the Asian countries affected by the late 1997 economic crises need to restructure their economies and strengthen their domestic financial systems mostly along similar lines. The robust growth experienced by market-based financial systems of the western countries can be traced at least partially to their practice of wide disclosure of credit information and the ability to adjust quickly by reacting to market feedbacks. In contrast, financial systems in Asian countries have traditionally emphasized relationships where business and credit information is exchanged mostly between the specific parties involved in particular financial transactions.

With the growth of international financial flows, clashes between these two contrasting systems and financial cultures are increasingly likely to create difficult and dangerous situations. Further, because of information asymmetry, the growth potential of relationship-based financial intermediation is relatively limited, and lending in such systems generally does not have adequate self correcting negative feedbacks. Thus, Asian financial systems need reform and restructuring.

Financial institutions and markets both need strengthening in Asian countries. For example, the banking systems of these Asian countries need reform to prevent 'crony capitalism' so that lending based on political connections can be replaced with publicly disclosed lending based on credit analysis. Reform efforts also need to focus on restructuring overextended companies and the development of regulations that require better accounting and higher levels of disclosure so that market discipline can supplement or replace government regulation of banks. As in Taiwan, bankruptcy laws should be reformed so it is easier for non-performing companies and banks in other parts of Asia to fail without great difficulty.

Similarly, financial markets in most Asian countries also need to be reformed and strengthened. Equity markets in the Asian countries most affected by the 1997 crises generally could benefit from better regulations requiring higher levels of corporate disclosure and having stronger prohibitions against insider trading and other unfair practices. More importantly, the domestic corporate bond markets in most of these Asian countries are not highly developed. Such bond markets are an essential part of robust capital markets and reduce the reliance on foreign currency debt.

Unfortunately, building robust financial markets is not an instantaneous process. It involves the development of an independent accounting profession, appropriate disclosure policies, enforceable property rights, well-regulated brokerage firms and markets for trading securities and derivatives, and independent institutions for the analysis of fundamental corporate and economic data. As these institutions develop and investors gain confidence in their ability and integrity, efficient trading can move progressively from low risk and short-term securities to higher risk and longer-term securities (e.g., from short-term government debt to long-term government and short-term prime corporate debt, to long-term prime and short-term sub-prime corporate debt and prime corporate equity, to sub-prime corporate equity and derivatives). Without the development of the supporting infrastructure discussed here, securities markets are likely to remain speculative and unlikely to intermediate significant proportions of nation al savings and capital.

Longer term, in addition to the reform of business regulations and banking practices along with the development of better accounting and disclosure regulations, most of these Asian countries will also need political reform to reduce the business influence of governments (e.g., Chanda, 1998). Some of these countries may also need temporary restrictions on the free cross-border flows of "hot capital" (e.g., short-term foreign portfolio investment) while they are developing more robust domestic financial systems that are able to participate in global markets. However, such restrictions also have serious negative aspects. To minimize such negative results, any restrictions on cross border financial flows must be strictly temporary as they do have a tendency to become permanent and they do slow down the need to develop robust domestic financial markets.

Need for International Cooperation

The economic recovery of the Asian countries also depends on the continuing health of the world economy, especially Western European and North American economies that are important markets for Asian products. Similarly, restoring economic growth in Japan is even more critical for Asian recovery especially as Japan is not only the second largest economy in the world and larger than the economy of the rest of the Asia, it is a very important trading and investment partner for the rest of Asia. Unfortunately, Japan had already been in a serious economic slowdown since the 1990 bursting of its bubble in asset prices. As the Japanese economy is heavily interdependent with other Asian economies, the continuing weakness of the Japanese economy and banking system means that recovery in other Asian economies is more difficult.

Asian economic recovery also needs international cooperation to avoid 1930s type competitive devaluations. As the Asian countries with devalued currencies try to increase their exports, China and other developing countries with competing exports face declines in their exports and, consequentially, temptations to devalue their currencies to stay competitive. Similarly, Japan and other industrial countries would face similar pressures from Korean companies. Such devaluations could start additional rounds of competitive devaluations. Somewhat offsetting such devaluation pressures is the fact that China, India, and Japan all have large domestic economies and such devaluation may not be of much relative importance. Nevertheless, in addition to internal reforms in Asian countries, international cooperation is essential to avoid a repeat of cycles of competitive devaluations that would acerbate any economic slowdown and turn it into a 1930s style depression.

Opportunities in Crises

It must be noted that the Asian countries currently in crises have been fundamentally very strong economies with excellent work ethics, high educational levels, strong private sectors, and high rates of saving and of growth-generating capital investment. Thus, as Asian asset prices have sunk to very low levels in local currency terms and even lower in dollar, pound, and mark terms, many Asian countries now present unusually good bargains especially for patient investors. These Asian countries also represent excellent opportunities for sourcing production and R&D, for cross-border acquisitions, mergers, and strategic alliances, and for other forms of direct investment.

As with all cross-border business activity, political and business risks must be assessed and balanced against diversification advantages and the gains associated with these highly discounted prices. This is especially true when investing in Asia. Although the worse of the current economic crises in Asia may be mainly over in many Asian countries, there is still the very real prospect of significant downturns in other Asian countries. In such cases, investors with relatively short time horizons may still want to avoid investing in at least some of the riskier Asian countries. On the other hand, investors with longer investment horizons, such as some portfolio investors and investors in real assets, may find many bargains in Asia. In fact, many large companies such as General Electric and General Motors are already making new direct investments in Asia and taking advantage of the new sourcing opportunities in Asia. Such sourcing and direct investment activities by western firms are also helping accelerate the economic recovery of these Asian countries.

The widely accepted consensus so far is that the benefits of economic globalization are greater than its occasional costs (e.g., Noland et al., 1998), and world economic growth would be much lower if wealth creating international trade and direct investment were reduced or restricted as a result of this Asian crises. International rescue efforts to support the Asian economies will not only limit negative contagion for the world economy, restoring the Asian countries as some of the most productive members of the global economy will be very good for the world economy.


The economic crises that hit the fast growing Asian countries in 1997 had a serious negative impact not only on these countries, but it also seems to have spilled over into a significant negative economic impact on other regions. The underlying cause of the economic crises in these otherwise strong economies, seems to be a combination of changing international competitive structure and inadequate domestic financial systems. Financial systems in these Asian countries are weak relative to the economic wealth and technological sophistication of these countries and have been characterized by high reliance on debt, especially on short-term debt, low levels of disclosure, and high influence of politics in capital allocation and other economic decision-making.

The analysis of the Asian economic crises presented here shows that positive feedbacks have played an important role in the development and global propagation of the Asian economic crises. Many of the positive feedback cycles, such as those between savings and investment, have been virtuous for the rapidly developing Asian countries. However, these and other positive feedback cycles turned from being virtuous to being vicious after the asset bubbles peaked and the downturn started. In market based economies with strong and well-developed domestic private financial markets and systems, market scrutiny and prices provide valuable negative feedbacks that are stabilizing. To protect their companies, many Asian governments followed and promoted policies that limited such negative feedback from market forces. Such policies and practices may have worked at an earlier stage of economic development, but with rising technology levels and globalization, the ability of any government to direct an economy have clearly be en declining in recent decades. The Asian governments are no exception and must turn increasingly to market forces to provide stabilizing negative feedbacks to balance the positive feedback mechanisms on which they have relied until now.

Economic recovery in Asia will require steps to strengthen domestic financial institutions and markets in each affected country, but each of these Asian countries also differ in their economic and political structures and, thus, are likely to follow somewhat different paths to economic recovery. Some Asian countries are likely to recover fairly rapidly as they have either been relatively less affected or have rapidly acknowledged their problems and the need for reform. Other Asian countries are taking longer to recognize or deal with their problems, have suffered major setbacks, and are likely to face a slow and uneven process of economic recovery.

Economic recovery in Asia will also require continuing international cooperation to forestall threats of 1930s type competitive devaluations, as well as continuing good growth prospects in Europe and America and economic recovery in Japan. In the meantime, the current depressed levels of exchange rates and asset prices in many Asian countries may represent some very attractive investment opportunities especially for investors that do not have a short investment horizon.

Acknowledgment: The author would like to thank Fred Luthans and his colleagues for useful comments but remains solely responsible for the contents.

Raj Aggarwal, Firestone Chair in Finance, Graduate School of Management, Kent State University, Kent, OH 44242.


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Author:Aggarwal, Raj
Publication:Journal of World Business
Date:Dec 22, 1999
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