Asian Financial crisis, also called the “Asian Contagion”, was a series of currency devaluations and other events that spread through many Asian markets beginning in the summer of 1997.Two main hypothesis and interpretations have emerged in the aftermath of the crisis. According to one view, sudden shifts in market expectations and confidence were the key sources of the initial financial turmoil, its propagation over time and regional contagion. Other view is that the crisis reflected structural and policy distortions in the countries of the region. Fundamental imbalances triggered the currency and financial crisis in 1997, even if, once the crisis started; market overreaction and herding caused the plunge of exchange rates, asset prices and economic activity to be more severe than warranted by the initial weak economic conditions.
As a result of the devaluation of Thailand’s baht, a large portion of East Asian currencies fell by as much as 38%. International stocks also declined as much as 60%. Luckily, the Asian financial crisis was stemmed somewhat by 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 own currencies. Often, this led to heavy buying of U.S treasuries, which are used as global investments by most of the world’s sovereignties. The Asian crisis led to some 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.
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 South Asia, in turn causing stock market declines, reduced import revenues and government upheaval.
The East Asia’s experience suggests that while a classic panic may have played a role, financial sector weaknesses were a major contributor to the recent financial crisis. Such weakness appear to reflect the inability of lenders to use business criteria in allocating credit and implicit or explicit government guarantees against risk. The lack of hedging at that time also added to the instability in Asian financial markets. After the pegs collapsed, borrowers who had not hedged their foreign currency borrowing had difficulty servicing their debts and in some cases went bankrupt, thus worsening the crisis. The high cost of abandoning currency pegs induced policymakers to adopt harsh contractionary measures (involving skyrocketing interest rates) to defend exchange rate, even when the pegs were unsustainable in the face of adverse market sentiment.