Revisiting the Asian Crisis and Its Challenge to Conventional Wisdom

Abstract

The Asian Crisis was a bout of intense turbulence that swept East Asian emerging markets, starting in mid-1997 and running through most of 1998. During this episode, a group of previously rapidly industrializing economies that had compiled an impressive record of sustained growth, been lauded for generally good economic policy and performance, and been highly attractive to foreign capital, suddenly suffered massive capital outflows, steep declines in domestic asset values, at times extreme exchange rate volatility, and deep declines in economic activity. Several required massive financial assistance from the international financial institutions, led by the International Monetary Fund (IMF), to restore stable financial conditions. What undermined East Asia’s success story? The "conventional wisdom" on the Asian Crisis is that the crisis was largely due to a combination of two factors: a build-up of financial fragility in the region during the preceding boom and inherent volatility in capital markets. This set the stage for a twin banking/balance of payments crisis that only awaited a trigger, such as an economic slowdown or weakening of exports, or indeed contagion from other economies, to be set in motion. Once underway, various factors that contribute to market volatility, such as herd behaviour of investors, are adduced to explain the actual course of the crisis, including the overshooting in financial markets. The vicious circle of financial crisis feeding real-side crisis, amplifying the financial crisis, and so forth, explains the depth of the crisis. This paper explores various troublesome features about this story. This review suggests that giving rein to scepticism about the accepted explanation may prove rewarding. And that indeed proves to be the case: the closer one looks at the conventional explanation for the Asian Crisis, the less compelling it becomes.

Keywords: Asian Crisis, contagion, capital flows, exchange rates

JEL Classification: F31, F32, F42