The Asian financial crisis of 1997-98 was similar to the crisis of 2007-08, and the fixes proposed a decade ago sound familiar, but they did not prevent the later panic because the developed world saw itself as more sophisticated and able to handle such problems, according to a new study by Galina Hale, a senior economist at the Federal Reserve Bank of San Francisco.
Underlying both crises were bank runs, especially on the repurchase market. Although Hale focuses mainly on currency mismatches and doesn’t mention the R-word (repo), her descriptions are telling:
East Asian financial systems were subject to two additional risk factors: maturity mismatches due to liabilities that were predominantly short-term and assets that were much longer term or illiquid, and excessive risk taking. Credit was available from abroad cheaply and in large quantities because of the implicit government guarantees. Banks were running out of low-risk projects to lend to and increasingly were financing riskier projects, thanks to an international lending boom and easy access to credit from abroad.
The date of the onset of the Asian financial crisis can be fixed precisely. On July 2, 1997, speculators attacked the Thai baht by selling off baht-denominated assets. Simultaneously, foreign investors withdrew dollar-denominated loans to Thai institutions. The Thai government was forced to let go of its currency peg. The baht plunged 16% on the day of the attack and lost over 50% of its value by January 1998. In the months that followed, other East Asian countries experienced similar debacles. Financial contagion spread through the region so fast that it was nicknamed the “Asian flu.” Only Hong Kong and China were able to maintain their currency pegs. The Hong Kong Monetary Authority intervened directly in the stock market, while China imposed capital controls.
Because of currency mismatches, bank and corporate balance sheets were under tremendous pressure as asset values declined dramatically relative to liabilities. To make matters worse, amid the speculative attacks, bank access to overseas credit dried up as foreign investors executed a flight to quality. Many overseas bank loans had relatively short maturities and banks were unable to roll them over as they had previously. In short, East Asian countries experienced severe banking crises. Nonperforming loan ratios skyrocketed because of prior excessive risk taking, and most banks had to be recapitalized by their governments. Before the crisis, most governments in the region had balanced or nearly balanced budgets. But the fiscal costs of bank recapitalization led to big deficits, forcing governments to seek funds from the International Monetary Fund (IMF).
Hale describes the fixes that economists recommended after the Asian crisis:
Economists formulated a number of policy recommendations aimed at preventing a repetition of Asian-flu-type crises. Bank regulators were encouraged to require greater transparency and supervise lending activity more strictly, paying particular attention to currency and maturity mismatches. Some scholars urged that highly leveraged institutions be required to improve risk assessment and reduce leverage ratios. Some argued for capital controls to lengthen the maturity and alter the composition of foreign capital inflows so that more investment came in as equity and less as debt. An international lender of last resort was needed to resolve crises, economists said, questioning whether the IMF could fulfill this role given its limited funds. Economists also called for private-sector contingent credit lines to manage liquidity problems. Private-sector involvement in crisis resolution was held to be vital, given the enormous volume of international capital flows.