What Was the Asian Financial Crisis?

The Asian financial crisis, also called the "Asian Contagion," was a sequence of currency devaluations and other events that began in the summer of 1997 and spread through many Asian markets. The currency markets first failed in Thailand as the result of the government's decision to no longer peg the local currency to the U.S. dollar (USD). Currency declines spread rapidly throughout East Asia, in turn causing stock market declines, reduced import revenues, and government upheaval.

Understanding the Asian Financial Crisis

As a result of the devaluation of Thailand's baht, a large portion of East Asian currencies fell by as much as 38 percent. International stocks also declined as much as 60 percent. Luckily, the Asian financial crisis was stemmed somewhat due to financial intervention from the International Monetary Fund and the World Bank. However, the market declines were also felt in the United States, Europe, and Russia as the Asian economies slumped.

As a result of the crisis, many nations adopted protectionist measures to ensure the stability of their currencies. This often led to heavy buying of U.S. Treasuries, which are used as global investments by most of the world's governments, monetary authorities, and major banks. The Asian crisis led to some much-needed financial and government reforms in countries such as Thailand, South Korea, Japan, and Indonesia. It also serves as a valuable case study for economists who try to understand the interwoven markets of today, especially as it relates to currency trading and national accounts management.

Causes of the Asian Financial Crisis

The crisis was rooted in several threads of industrial, financial, and monetary phenomena. In general, many of these relate to the economic strategy of export led growth that had been adopted across developing East Asian economies in the years leading up to the crisis. This strategy involves close government co-operation with manufacturers of export products, including subsidies, favorable financial deals, and a currency peg to the U.S. dollar to ensure an exchange rate favorable to exporters.

While this benefited the growing industries of East Asia, it also involved some risks. Explicit and implicit government guarantees to bail out domestic industries and banks; cozy relationships between East Asian conglomerates, financial institutions, and regulators; and a wash of foreign financial inflows with little attention to potential risks, all contributed to a massive moral hazard in East Asian economies, encouraging major investment in marginal, and potentially unsound projects.

With the reversal of Plaza Accord in 1995, the governments of the U.S., Germany, and Japan agreed to coordinate to let the U.S. dollar appreciate relative to the yen and the Deutsche Mark. This also meant the appreciation of East Asian currencies that were pegged to the U.S. dollar, which led to major financial pressures accumulating in these economies as Japanese and German exports became more and more competitive with other East Asian exports. Exports slumped and corporate profits declined. East Asian governments and connected financial institutions found it increasingly difficult to borrow in U.S. dollars to subsidize their domestic industries and also maintain their currency pegs. These pressures came to a head in 1997 as one after another they abandoned their pegs and devalued their currencies.

Response to the Asian Financial Crisis

As mentioned above, the IMF intervened, providing loans to stabilize the Asian economies—also known as “tiger economies”—that were affected. Roughly $110 billion in short-term loans were advanced to Thailand, Indonesia, and South Korea to help them stabilize their economies. In turn, they had to follow strict conditions including higher taxes and interest rates, and a drop in public spending. Many of the countries affected were beginning to show signs of recovery by 1999. 

Lessons Learned From the Asian Financial Crisis

Many of the lessons learned from the Asian financial crisis can still be applied to situations happening today and can also be used to help alleviate problems in the future. First, investors should beware of asset bubbles—some of them may end up bursting, leaving investors in the lurch once they do. Another possible lesson is for governments to keep an eye on spending. Any infrastructure spending dictated by the government could have contributed to the asset bubbles that caused this crisis—and the same can also be true of any future events. 

Modern Case of the Asian Financial Crisis

The world markets have fluctuated greatly over the past two years, from the beginning of 2015 through the second quarter of 2016. This caused the Federal Reserve to fear the possibility of a second Asian financial crisis. For example, China sent a shockwave through equity markets in the United States on August 11, 2015, when it devalued the yuan against the USD. This caused the Chinese economy to slow, resulting in lower domestic interest rates and a large amount of bond float.

The low interest rates enacted by China encouraged other Asian countries to decrease their domestic interest rates. Japan, for example, cut its already-low short-term interest rates into the negative numbers in early 2016. This prolonged period of low interest rates forced Japan to borrow increasingly larger sums of money to invest in global equities markets. The Japanese yen responded counterintuitively by increasing in value, making Japanese products more expensive and further weakening its economy.

The U.S. equity markets responded with a drop of 11.5 percent from January 1 to February 11, 2016. While the markets have since rebounded by 13 percent from February 11 to April 13, 2016, the Fed is still concerned about continued volatility throughout the rest of 2016.