Economic and Financial Turmoil in South-East Asia: Origins and Consequences

Current Issues Brief 8 1997-98

Phil Hanratty
Economics, Commerce and Industrial Relations Group
2 December 1997


Major Issues Summary


Origins of the Turmoil

Further Economic and Financial Problems

Effects on North-East Asia

Effects on Australia


Major Issues Summary

After a decade or more of rapid economic growth, many of the countries of South-East Asia are now facing serious economic and financial problems. These problems involve both immediate crisis management in unstable financial markets and the medium-term restructuring and repositioning of their economies in the face of intensified export competition.

These countries are highly likely to experience substantially lower economic growth in the short term as they cope with these difficulties. These issues and problems were considered of sufficient importance to be a major topic of discussion at the recent APEC Leaders' Meeting in Vancouver.

Countries such as Thailand, Malaysia, Indonesia and the Philippines have experienced large exchange rate devaluations as international and local financial interests speculated that existing exchange rate levels could not be sustained in the face of large external deficits, inflation differentials and high domestic growth; this speculation actually provoked the devaluations.

These devaluations have in turn prompted monetary and fiscal policy tightening to help cope with the inflationary effects of the devaluations and to help rein in the external deficits. Falls in general economic confidence and these policy tightenings are both likely to reduce economic growth in these countries in the short term.

Once these short-term economic effects have been digested, exports from these countries will expand under the influence of the exchange rate devaluations. Such export growth will help generate broader recoveries in economic growth in these countries, so long as their financial sector problems have been brought under control and then adequately resolved.

Asset price inflation and then deflation, under the influence of speculative activity, has substantially increased the level of bad/non-performing loans in these countries, especially in the commercial property sector. This has in turn made a number of financial institutions insolvent. Some have been closed down under Government rationalisation plans, but more thoroughgoing restructuring of financial systems, and financial regulation, is probably necessary.

In the case of Thailand and Indonesia, these policy actions have been supported by financial assistance packages arranged through the International Monetary Fund (IMF). Australia has contributed to the Thailand package in the form of a 'currency swap' up to the value of US$ 1 billion. It has also contributed to the Indonesian package in the form of a promise to make available loan funds up to the value of US$ 1 billion if these are needed by Indonesia.

This turmoil in South-East Asia is also likely to contribute to lower economic growth in North-East Asian countries such as Japan and South Korea. Their export growth to South-East Asia will fall, more of their loans to borrowers in South-East Asia will default and their investments there will be devalued and profit remittances reduced.

South Korea is now experiencing similar problems to those of South-East Asia: large forced currency devaluations, rising levels of bad loans, and loss of economic confidence. At the time of writing, a large financial assistance package is being organised through the IMF for this country and it is expected that Australia will contribute to it.

As well, this turmoil might be just the psychological and financial blow which pushes Japan back into economic stagnation, since its economic recovery from recession has been fragile and faltering. Its longstanding financial problems of large levels of bad loans and effectively insolvent financial institutions have not been adequately resolved.

Nevertheless, the strong 'economic fundamentals' of high rates of investment, saving, technological transfer and expansion in education and training throughout Asia mean that the medium to longer term prospects for growth in the region remain very good. This also means that prospects for Australian exports to Asia remain good in the medium to longer term.

Australian economic growth in the short term is likely to be lower than it otherwise would be because of the South-East Asian crisis. Estimates of the fall in annual Australian growth over the next year or two currently range between 0.2 and 1.0 percentage points. This prospect poses serious problems for Australian economic policy. This is because the expected recovery in the growth of Australian output and employment now looks likely to be substantially nullified by the effects of the Asian turmoil.


Most of South-East Asia has enjoyed rapid economic growth and development in recent years: see Table 1. However, many of these countries now face difficult economic problems. These involve both immediate crisis management in unstable financial markets, and the need for longer-term adjustment and restructuring of their economies. These difficulties are likely to produce lower economic growth in the region in the short to medium term. Australian economic growth is also likely to be lower as a result. The remainder of this paper discusses these issues in more detail.

Table 1

Growth Rates of Real GDP (%)























































Source: International Monetary Fund, World Economic Outlook, October 1997: pp. 148 and 155.

Origins of the Turmoil

Countries such as Thailand, Indonesia, Malaysia and the Philippines have embraced an unusual policy combination of liberalisation of controls on flows of financial capital on the one hand, and quasi-fixed/ heavily managed exchange rate systems on the other. These exchange rate systems have been operated largely through linkages with the United States (US) dollar as their anchor.(1) Such external policy mixes are only sustainable in the longer term if there is close harmonisation of economic/ financial policies and conditions with those of the anchor country (in this case, the United States). Otherwise, destabilising capital flows will inevitably undermine the exchange rate.

Rather than harmonisation, there seems to have actually been increased economic and financial divergence with the US in recent times, especially in terms of current account deficits, inflation and interest rates. These increasing disparities have prompted global (and local) financial interests to speculate against the administered exchange rate linkages, i.e. speculative pressure mounted that the monetary authorities in these countries would not be able to hold their exchange rate links. In most cases, such financial speculation has been of sufficient magnitude to actually provoke the collapse of the administered exchange rate links, in the manner of 'self fulfilling' prophecies. Defence of the exchange rate through the use of foreign exchange reserves and higher interest rates proved to be insufficient.(2)

The result has been large devaluations of the exchange rates of these countries, especially against the US dollar; large interest rate increases to support the exchange rates at their new lower levels (to prevent wholesale over-reaction and collapse in foreign exchange markets and to help contain the strong inflationary forces thus set in motion); and extra restrictions in fiscal policy designed to raise national saving, contain domestic spending and reassure foreign investors and international institutions such as the International Monetary Fund (IMF). Figure 1 shows the magnitude of these recent devaluations.

Figure 1: Exchange Rate Indices (US$ per national currency unit) Jan 1996 to Nov 1997

The IMF has arranged conditional financial support packages for Thailand and Indonesia; Australia is contributing to both efforts.(3) Financial support is provided in exchange for (on condition of) economic policy reforms which, it is argued, will encourage economic recovery and help prevent a recurrence of the turmoil these countries are now experiencing. Australia's help to Thailand has taken the form of a 'currency swap' where Australia's US dollar assets of up to $1 billion were exchanged for Thai Baht, with an agreement that the reverse exchange would occur at a future point in time. Australia's help to Indonesia has so far taken the form of a pledge to make available loans up to the value of US $1 billion if these are needed to stabilise financial conditions there.(4)

These financial crises have also provoked substantial falls in the stock markets of these countries and in other parts of Asia. (They also contributed to stock market falls around the world). Foreign investor funds would have been initially withdrawn as exchange rate speculation mounted, and this would have partly taken the form of a sell off of foreign-owned stock. As well, much higher interest rates (both before and after the currency devaluations) encourage flows of funds out of shares and into loan/ debt-type assets. In turn, higher interest rates and lower exchange rates have substantially increased the rate of collapse/ bankruptcy of businesses operating in highly leveraged sectors (especially where loan contracts were written in foreign currency), and this would have further undermined confidence in the stock markets throughout Asia. Figure 2 shows the recent stock market price falls in these countries.

Figure 2: Stock Exchange Price Indicies Jan 1996 to Nov 1997

Overall, reductions in the growth of spending, production and employment in the region are likely to be prominent consequences of these financial crises, both as the direct result of the financial disruptions and also as the result of consequent contractionary economic policy changes which have been, and will be, implemented. Loss of general economic and financial confidence will reduce the growth in spending and output and these effects will be reinforced by the related tightening of fiscal and monetary policy.(5) Economic growth in these countries in the next couple of years will probably be substantially lower, and countries such as Thailand may actually tip over into recession, i.e. its absolute level of output may fall.

This downturn is likely to continue until the inflationary forces unleashed by the large exchange rate devaluations have been tamed, foreign exchange markets stabilise at their new lower prices, and the enhanced international trade competitiveness of these countries (arising largely from the currency devaluations) allows them to better implement export-led growth strategies. Such strategies have traditionally been the most successful and effective means of encouraging growth in Asia.

Thailand and Indonesia seem to have been the worst affected by the economic and financial crisis of the last several months; at the time of writing, they are the only two countries in the region to have received IMF-organised assistance. Malaysia and the Philippines seem to be in somewhat better economic and financial shape, at least compared with Thailand and Indonesia. Singapore appears in turn to be much better placed than the rest of the region and is likely to have the least economic and financial problems. This is because of the latter's more advanced economic structure, more sophisticated financial system, more flexible exchange rate system and substantial current account surpluses (in contrast to the deficits elsewhere in the region).(6)

Further Economic and Financial Problems

Enhanced trade competitiveness will also help these countries better deal with their longer-term problems of repositioning their economies in a region where trade competition has intensified and where domestic policy directions have often been counter-productive. Competition from China and other developing countries in standardised products which make intensive use of low-skilled/ semi-skilled labour have reduced export growth in South-East Asia at the same time as imports of capital goods in the region have continued to grow strongly. (China has also been much assisted by earlier large exchange rate devaluations). These trends have contributed to large and increasing trade and current account deficits in the region, and this seems to have been one of the fundamental reasons why speculators and other financial interests began to move against many of the currencies of South-East Asia.

While much of the high rates of investment in these countries have been directed towards efficient and productive uses, a substantial part has gone into industries unsuited to the economic conditions of these countries (such as 'national car' projects), or into sectors (such as commercial property) where asset price inflation has distorted investment priorities and taken capital away from more efficient uses. Thus, the productivity of such investment has been lower than expected and has not contributed much to the ability of these countries to fund their capital imports.

The bursting of asset price inflation bubbles, fuelled and then undermined by speculative activity, has also contributed to the economic and financial crisis which is unfolding (especially in countries such as Thailand). This in turn has rapidly increased the amount of bad/non-performing loans in the banking systems of these countries (and for foreign lenders such as the Japanese banks) and has forced the closure or consolidation/ merger of a number of lending institutions already, with many more to follow. Thus, the crisis has enveloped the financial systems in the region, and has been accentuated by high rates of borrowing. Its resolution will also require structural reform of financial institutions.(7) The prudential regulation of financial institutions will probably also have to be drastically upgraded in these financial systems.

Asset price deflation, rising bad debts and failing banks provide a very dangerous mixture for national economic performance and may require several years of adjustment before they can be fully overcome. The case of Japan is both instructive and rather frightening. After rapid Japanese asset price inflation in the 1980s (especially in property and shares), the early 1990s there saw asset price crashes, escalating bad debts (since these were often secured against the now vastly devalued assets) and banks teetering on collapse. Japan has seen very low economic growth in the last six years as it has attempted (ineffectively) to cope with such deep-seated financial problems.

It is now clear that the Japanese financial sector has not been rationalised in the thoroughgoing way needed for strong economic recovery. Insolvent institutions beyond hope of trading their way out of trouble have not been closed but have been allowed to linger on. Bad loans beyond any genuine hope of recoupment have not been written off against shareholder capital and/or government funds but have remained hidden in the 'nether regions' of institutions' balance sheets. (8)However, more resolute action by Japanese financial regulators may now be forthcoming.

It can only be hoped that the countries of South-East Asia fare better but this will require rapid, concerted responses to the problems confronting them. The policy responses so far announced have been reasonably encouraging but much more needs to be done.(9)

Effects on North-East Asia

Substantially lower growth in South-East Asia will have significant effects on the rest of Asia and on Australia. Much of the rest of Asia is quite heavily enmeshed in economic relations with South-East Asia and will thus bear some direct adverse effects of slower growth in the region. This seems especially true of Japan and South Korea, whose growth can be expected to be slower as their exports to the region face declining growth, more of their loans incur default, and their investments there are devalued and profit remittances are reduced. China and Taiwan must also be adversely affected to some extent. China's export growth is likely to be reduced by intensified trade competition from South-East Asian countries whose exporters have been energised by their currency devaluations.

South Korea is itself currently experiencing similar problems to those in South-East Asia. External deficits, inflation differentials and speculative financial activity have generated pressure upon the administered exchange rate system which policymakers have not been able to resist. Large forced devaluations, higher interest rates, rapidly rising levels of bad loans, falling stock markets and general loss of economic confidence have ensued.(10) Korean economic growth may thus fall substantially in the next couple of years. At the time of writing, South Korea is negotiating a financial assistance package, which is being organised through the IMF, to help stabilise volatile financial markets.(11)

Such an adverse economic shock also comes at an inopportune time for Japan where economic recovery has been faltering and fragile. Crisis in South-East Asia might be just the psychological and financial blow which seriously undermines Japanese recovery and sends it sliding back into stagnation.(12) This is especially worrying since Japanese policymakers seem to have run out of ways of stimulating economic activity. Ominously, specific information is just starting to emerge about increases in bad/non-performing loans amongst the portfolio of loans made by Japanese banks to borrowers in South-East Asia (and to South Korean borrowers also). This could further scare and destabilise financial markets in the region, and around the globe.

Effects on Australia

Australia's rapidly growing export markets in South-East Asia will probably be cut back substantially in the next couple of years. This is both because slower growth in the region will reduce the growth in demand for Australian exports, and also because the much lower real (inflation-adjusted) exchange rates of South-East Asian countries will further reduce their imports by favouring domestic production; the latter effect will also favour their exports. Further 'second round' adverse effects on our major trading partners such as Japan and South Korea will be important to Australia.

Similarly, Australian exports to Asia can be expected to eventually recover when exports from these South-East Asian countries themselves accelerate under the influence of their devalued exchange rates. The latter export expansion will then help to generate broader recoveries in economic growth in the region.

The strong 'economic fundamentals' of high rates of investment, saving, technological transfer, and expansion in education and training throughout Asia all point to the region recovering to robust economic growth once the current set of problems have been dealt with. (The crucial proviso is probably that financial sector problems in the region be effectively resolved). Thus, the medium to longer term prospects for Australian exports to Asia remain strong so long as our producers continue to be competitive in terms of price and quality.

Estimates of reductions in Australian economic growth resulting from this negative external shock currently range from 0.2 to 1.0 percentage point falls in the next year or two.(13) Initial estimates were at the low end of the range, but more recent forecasts have generally been higher, as more adverse information has been received. (Falling growth in Australian exports is likely to be reinforced by cuts to investment and consumption plans).

These estimates pose serious problems for the Australian economy and Australian economic policymakers. Most importantly, they imply that Australian economic recovery in the growth of output and employment, which according to many forecasters already looks to be only quite moderate and gradual, could be substantially nullified by the external economic shock emanating from South-East Asia, and its flow-on effects on North-East Asia.(14)

Difficult dilemmas for the current setting of Australian monetary and fiscal policy are thus created. For example, disturbances to Australian financial markets caused by the crisis mitigate against any current relaxation of monetary policy arising from consideration of the need to counter the external economic shock proactively.

This is especially so in the case of the recent fall in the Australian dollar; this acts to encourage net exports and helps to counter the external shock (but also adds to domestic inflationary pressures, mainly through higher import prices). However, this devaluation could prove to be substantially the result of financial market over-reaction and thus could be quite temporary in nature. Unfortunately, this may not become clear until 1998, by which time a further reduction in official interest rates might be rather late in terms of dampening the external shock. The enduring currency devaluation may be insufficient in itself to dampen the external shock substantially.

On the other hand, even if monetary policy is relaxed now this will do little to nullify the shock's effect on Australian spending and growth in calendar year 1998. This is because of the substantial time lags involved in the impact of such monetary policy changes on the economy. However, such a policy relaxation could help to bolster growth after next calendar year, if the effects of the crisis on Australia are expected to last that long.

Monetary policymakers also seem to be restrained at the present time by uncertainty about the magnitude and duration of the economic effects of the Asian crisis on Australia, and its effects upon the future course of Australian inflation in particular.(15) This also comes at a time when official forecasts already see inflation rising back into its target range, in 1998, of 2-3% underlying inflation.(16)

Fiscal/ budgetary policy might also help to dampen the shock by temporarily moving to a more expansionary/less restrictive stance. It is an attractive policy tool since it has shorter lags of impact on the economy than monetary policy and is less likely to generate exchange rate devaluation (and consequent intensified inflation pressures) than monetary policy. This might allow stronger growth while also allowing the inflation target to continue to be met.

However, fiscal policy is currently in a contractionary stance at the Federal level, being preoccupied with budget deficit reduction to boost levels of national saving and help contain current account deficits. Indeed, Australia's current account deficit is highly likely to increase as a result of the negative external shock arising from Asia, and this mitigates against any move to fiscal policy expansion.



  1. International Monetary Fund, World Economic Outlook, October 1997, Table 16.

  2. ibid, pp. 37-39.

  3. 'The IMF and Indonesia: Baleful Bonanza', The Economist, 8 November 1997, p. 95.

  4. Commonwealth of Australia, The Treasurer (Peter Costello, MP), Press Statement No. 90, 11 August 1997, and Press Statement No. 116, 1 November 1997.

  5. For a critical perspective on such policy changes, see: Greg Earl, 'IMF Solution Follows Wrong Track: Economists', Australian Financial Review, 19 November 1997, p. 13.

  6. Economist Intelligence Unit, Country Report: Singapore, London, 3rd quarter, 1997, pp. 23-26.

  7. Simon Davies and John Ridding, 'Crisis Into Catastrophe?', Financial Times (London), 31 October 1997, p. 15.

  8. Max Walsh, 'Aid Parcels to Japanese Banks', The Sydney Morning Herald, 18 November 1997, pp. 25-26; Max Walsh, 'Time for Japan to Save the World', The Sydney Morning Herald, 21 November 1997, pp. 29-30.

  9. John McBeth, 'Big is Best: Indonesia's Rescue Package Draws on the Thai Experience', Far Eastern Economic Review, 13 November 1997, pp. 68-69; Greg Sheridan, 'The Asian Malaise is Curable', The Australian, 28 November 1997, p. 13.

  10. Charles Lee, 'The Next Domino ?', Far Eastern Economic Review, 20 November 1997, pp. 14-16.

  11. Eric Ellis, 'Kim Inspects Mouth of IMF Gift Horse', Australian Financial Review, 24 November 1997, p. 12.

  12. Teresa Wyszomierski and Christopher Lingle, "Fortress Japan Under Siege', Australian Financial Review, 19 November 1997, p. 20.

  13. Ian MacFarlane, Governor of the Reserve Bank of Australia, Testimony to the House of Representatives Standing Committee on Financial Institutions and Public Administration, Sydney, 6 November 1997; Chris Caton, 'Crisis Flow-On Minimal', The Australian, 4 November 1997, p. 13; Peter Brain et al, Press Statement, National Institute of Economic and Industry Research Pty Ltd, 5 November 1997.

  14. Chris Caton, 'Crisis Flow-on Minimal', The Australian, 4 November 1997, p. 13; Sean Aylmer, 'Australian Growth Forecasts Lowered', The Sydney Morning Herald, 20 November 1997, pp. 29-30.

  15. Reserve Bank of Australia, Semi-Annual Statement on Monetary Policy, November 1997, pp. 2-13.

  16. ibid, p. 40.