25 Years After the East Asian Financial Crisis: 2 Forgotten Lessons

My friend Bert Hofman, director of the East Asia Institute at the National University of Singapore, has just written an insightful account of the financial crisis in East Asia. On July 2, 1997, exactly 25 years ago, the Thai authorities devalued the baht, triggering a wave of economic crises in East Asia that reverberated through other emerging economies, including Russia and Brazil.

Much has been written about the causes of the East Asian crisis and the policy responses of various countries. The crisis triggered a wave of structural reforms that undoubtedly strengthened the East Asian economies to the point where they were largely unaffected by the 2008 Great Recession and the 2009 Great Financial Recession. It also appears to have spurred a culture of learning that has spread to other areas: Asian experiences in dealing with SARS and avian flu outbreaks in 2003 helped them build public health systems that were effective in fighting the coronavirus.

However, there are two lessons from the East Asian financial crisis that seem to have been forgotten but are relevant to today’s economic problems.

The first lesson is that when the economy is built on the wrong foundation, growth is not always good. This may simply lead to an accumulation of risk. In the case of East Asia, the crack in the foundation was the assumption that pegging the currency to the US dollar through a fixed exchange rate would make little difference. These bindings were not formal, but institutionalized into norms of behavior. East Asian executives, with their export orientation and strong ties in global supply chains, were commonly described as having “fear of swimming. “Banks, businesses, and government officials have for years assumed that any deviation in their currency’s bilateral exchange rates against the US dollar would be minimal.

Despite all the talk and warnings about “abandoned assets”, businesses, financial institutions and many governments, including those in developing countries, are still increasing the impact of fossil fuels. This is dangerous.

The result was a huge accumulation of currency mismatches in balance sheets. Major real estate and construction companies in the region have created real estate assets financed by US dollar loans. Banks and financial institutions used loans from abroad to expand credit to domestic enterprises and small and medium-sized enterprises. Governments used forward markets to hide the size of their net foreign exchange reserves against which domestic loans were issued.

The consequence of these currency mismatches in many balance sheets is that when currencies were adjusted in the face of dollar shortages, the economic damage was devastating. The exact timing of the crisis in Thailand and its spread to other countries is still the subject of serious scientific debate. My personal preference is for the depreciation of the yen after 1995, which caused Japanese banks to shrink their balance sheets and reduce their dollar credit risk—a $100 billion capital flight out of the region in a few months. But what I really want to say is that the external shock has had a huge economic impact even on countries that have long been considered successful.

What is the relevance today? Again, we see an economy built on a false foundation – fossil fuels. We are in another energy crisis, but the answer in advanced economies is to double oil and coal production, not to accelerate structural reforms in transition economies on a more sustainable basis. For all the talk and warnings about “abandoned assets“Companies, financial institutions and many governments, including those in developing countries, continue to increasingly use fossil fuels. This is dangerous.

The second forgotten lesson from the East Asian crisis is that the emergence of debt crises has more to do with weak institutions and low resilience than debt performance. Each of the affected East Asian countries had relatively strong macroeconomic indicators—low levels of public debt, strong growth, prudent budget and current account balances, and low inflation. However, when the crisis hit, governments had to take on heavy debts to save banks and businesses (and in some cases, keep social safety nets for the poorest). Their finances were not sustainable.

Today we hear concerns that the investments of developing country governments in climate resilience are not affordable due to their high levels of debt. The transition from disaster response to disaster risk reduction is on hold. Nature-based solutions and investments in human capital that increase resilience are being delayed. This is a backward economy. The risks of a debt crisis in developing countries are growing not because of excessive spending by governments, but because of reduced access to financing for key resilience projects.

So, 25 years after the East Asian crisis, let’s remember two things. When the economic fundamentals are imperfect, it is never too early to begin the transition to a sustainable structure. Growth can otherwise be sustained for several years, but is subject to much more severe downturns when the crisis strikes. And let’s focus more on public institutions and the soundness of public finances when we think about creditworthiness, and less on numerical debt thresholds with little explanatory power when predicting debt crises when we assess the size and distribution of public spending. Ignoring these lessons makes the global economy weaker today than it should be.