Southeast Asia's economic crisis

Contemporary Review, Jan, 1998 by Donghyun Park

In particular, Indonesia, Thailand, Malaysia and Singapore have been characterized by an influential 1993 World Bank Report as economic miracles, along with the Northeast Asian economies of Japan, South Korea, Taiwan and Hong Kong. The fast growth of the region accelerated even more during recent years - with per capita real income rising by 8.4 per cent, 6.0 per cent, 5.7 per cent and 6.2 per cent in Indonesia, Thailand, Malaysia and Singapore respectively during the period 1985-1995. There have been signs of a turnaround even in the Philippines, for years the region's main underachiever. It seemed as if nothing could break the momentum of the region as foreign economists vied with each other to heap their eulogies and foreign fund managers competed with one another for investment opportunities in the 'tiger economies'. Until now that is.

Southeast Asian economies are currently in the midst of a most traumatic rude awakening. The numbers sum up the story and they are quite sobering. Between December 31, 1996 and October 22, 1997, the main stock exchange indices of Indonesia, Thailand, Malaysia, Singapore and the Philippines fell by 20.7 per cent, 38.5 per cent, 40.9 per cent, 21.9 per cent and 39.2 per cent respectively in local currency terms while the value of their currencies declined by 37 per cent, 34 per cent, 26 per cent, 10 per cent and 25 per cent against the US dollar respectively. Just as significantly, the slowdown shows no signs of ending anytime soon and the consensus in the financial markets seems to be that the situation is bound to get worse before it gets better. Furthermore, the contagion is spreading toward the region's periphery as well as beyond, as witnessed by Vietnam's devaluation of its currency on October 14 and Hong Kong's stock market plunge on October 23 and the collapse of one of Japan's largest brokers, Yamaichi on November 24.

There are two key questions we seek to briefly analyze in this article. First, what went wrong? That is, how can we explain this sudden negative turn for the worse in a part of the world which was bursting with so much dynamism and optimism as recently as the first half of 1997? Second, what are the prospects for recovery? What are the necessary adjustments the Southeast Asian economies must make in order to pull themselves out of their present morass and what are the chances that they will in fact be able to make those adjustments? These questions are relevant not only for the region's more than 450 million inhabitants but to the world at large insofar as they contain valuable general lessons about avoiding economic policy mistakes and making amends once they have been committed.

The forced devaluation of the Thai baht on July 2 provides the logical point of departure for our discussion because the event served as the catalyst of the current economic malaise hanging over Southeast Asia. The devaluation was forced in the sense that the Thai authorities had little choice in the decision. The baht, which had been pegged to a basket of foreign currencies dominated by the US dollar, came under unrelenting speculative attacks since May and the central bank, having spent billions of dollars of foreign reserves trying to defend the peg, was running out of ammunition. Avoiding a devaluation had been something of a matter of national pride in Thailand but in the end it became apparent to all that further defence would have been futile and common sense prevailed.

Of course, what really matters is why things came to such a pass in the first place. The Thai economy's weaknesses did not develop out of the blue. In fact, the International Monetary Fund (IMF) had warned Thai authorities about structural problems during its annual consultations held in July 1996, almost a year to the day before the devaluation debacle. The most serious of those problems was a large current account deficit, amounting to some 8 per cent of gross domestic product, which was financed largely by inflows of speculative short-term capital. That is to say, Thailand was living way beyond its means with borrowings from foreign sources without any long-term interests in the country. As a result, the national debt had ballooned from US$20 billion to around US$90 billion by early 1997. This is exactly the type of situation which precipitated Mexico's currency crisis in December 1994. As was the case with Mexico at that time, a large deficit financed by volatile foreign capital left Thailand extremely vulnerable to a negative swing in market sentiment as well as adverse economic shocks which would impair the country's ability to repay its debts.

Thailand's fixed exchange rate system contributed to its over-exposure in an important way because its existence attracted the inflow of short-term foreign capital by eliminating the risk of losses due to changes in the exchange rate. Of course, the same system had also served Thailand well in the past by attracting foreign capital of a more long-term nature, namely foreign direct investment. In fact, such investment, a large part of which came from Japan, was the driving engine of Thailand's impressive economic performance. Yet by the beginning of 1997 the fixed exchange rate system was becoming more of a liability than an asset in light of the vulnerability mentioned above. The system had outlived its usefulness and was becoming an increasingly tempting sitting duck for foreign exchange speculators.