1. Abstract
The East Asian financial crisis has been one of the most controversial issues since it
was precipitated in the mid of 1997. The debate included various aspects such as the
causes of the crisis the measures imposed by the IMF and even the " Help yourself"
package adopted by the Malaysian government. There are two main arguments about
the causes of the crisis. The first attributed the principal causes to the existence of
fundamental weaknesses and Moral hazard in the Asian economies. Whereas the
second attributed the main causes to financial panic as well as the absence of lender
of the last resort. In addition both arguments included the political instability and
policy mistakes resulted from government intervention in the economy as one of the
causes. Also the role of the IMF in handling the crisis was heavily criticized to the
extent that some economists contended that the IMF measures made the crisis worse
rather than better. In the mean time, the controversy included the efficiency of the
capital controls imposed in Malaysia to overcome the crisis. In this paper I will
review the main causes of the crisis, as well as comparing between the IMF measures
and the Malaysian "Help yourself strategy". Finally, I will try to address some of the
lessons that we have learned so far from the Asian crisis.

2. Introduction
The East Asian financial crisis has been one of the most observable issues
since it was triggered in mid 1997. It has been the sharpest financial crisis to hit the
developing world since the debt crisis of 1982 (Radelet and Sachs, 1998). Also, it
was described as the most serious financial and economic crisis in the world since the
Second World War (McNeill and Bockman, 1998). The crisis hit the Asian Tigers or
economies with the highest growth rates in the world, at that time. Additionally the
crisis, as contended by Radelet and Sachs (1998), prompted the largest financial
bailouts in the history.
In fact, the Asian crisis was triggered subsequent to a decade of unusual success for
the Asian economies. The international financial community, before the crisis, largely
invested in the Asian countries recognizing them as the most rapidly growing
economies in the world. According to the Institute for International Finance, the
capital inflows to the Asian five increased from average of 1.4% of GDP between
1986 and 1990 to 6.7% between 1990 and 1996. The highest capital inflows were
directed to Thailand with average of 10.3% of GDP in the period from 1990 to 1996.
Most of these inflows came from offshore borrowings by banks and finance
companies.
In essence, these high proportions of capital inflows resulted mainly from the new
policies of highly integrated and liberalized international capital markets.
Additionally, low interest rates in the United States and Japan facilitated the flow of
these investments towards the emerging markets in the Asian region. Finally, high
growth rates realized by foreign investors in the Asian region increased their
confidence in these emerging economies. Furthermore, there were some internal
factors contributed to these massive capital inflows such as the lack of supervision
2

3. and deregulation allowed domestic banks and finance companies to overborrow from
foreign banks to finance local projects, the special incentives given by the
governments of the region to promote investing in their countries, and finally the
pegged exchange rate policy and its relative stability, regardless of its drawbacks,
decreased the uncertainty and risk perceived by foreign investors.
Suddenly, and unpredictably, these capital inflows were reversed. According to the
Institute for International Finance as quoted in Radelet and Sachs (1998), the net
private inflows dropped from $93 billion to - $12.1 billion, a swing of 11% of GDP.
Therefore, Radelet and Sachs (1998) stated, "In this sense, the Asian Crisis can be
understood as a 'crisis of success', caused by a boom of international lending
followed by a sudden withdrawal of funds". Another factor that contributed to the
interestingness of the crisis is its unpredictability. "The crisis was largely
unanticipated. Although a small number of market participants were concerned ex
ante, the vast majority of players did not view the southeast Asian economies as
bubbles waiting to burst"1
.
In fact, Radelet and Sachs (1998) cited some evidence of the unpredictability of the
crisis such as, the strong capital inflows through 1996 and in most cases till mid
1997, Standard and Poor's and Moody's ratings of sovereign bonds remained
unchanged and did not signal any doubts of crisis. Finally they stated that the IMF
Executive Board expressed some concerns about the Asian economies, but in the
context of overall optimism. The only indicator of the crisis, as argued by them, was
the stock prices before the crisis. The Thai main index fell about 60% between 1996
and mid 1997. The prices in the Korean stock exchange, also, slumped sharply in
early 1997. In Malaysia the stock market began to slump in March 1997.
1
The Onset of the East Asian Financial Crisis, Steven Radelet and Jeffrey Sachs (1998).
3

4. What Caused The Asian Financial Crisis?
In fact the answer to this question is quite controversial. On one extreme some
economists attributed the main causes to the existence of structural problems and
fundamental weaknesses in the Asian economies such as current account deficits,
maturity mismatch, moral hazard, crony capitalism and price bubbles "As it turned
out in 1997 Asian economies did indeed experience a severe financial crisis. And with
the benefit of hindsight, several weaknesses in their economic structures--some
shared by Latin American countries that had gone through crisis--became apparent"
2
.
At the other extreme, others attributed the principal causes to financial panic, highly
liberalized financial systems as well as the absence of lender of the last resort "A
combination of panic on the part of the international investment community, policy
mistakes at the onset of the crisis by Asian governments, and poorly designed
international rescue programs turned the withdrawal of foreign capital into a full-
fledged financial panic, and deepened the crisis more than was either necessary or
inevitable"3
. In addition, both arguments included the political instability and policy
mistakes resulted from government intervention in the economy as one of the causes.
The most amazing thing in this debate is that neither of the two schools of thought
denied the rationality of the causes claimed by the other, however the debate focused
on the degree to which each group of causes mainly induced the crisis. But before
further exploring this quite interesting debate, it is useful to briefly introduce, in the
next section, how the crisis was initially emerged.
2
International Economics Paul R. Krugman and Maurice Obstfeld 5th edition, Addison Wesley
(2000).
3
The Onset of the East Asian Financial Crisis, Steven Radelet and Jeffrey Sachs (1998).
4

5. The purpose of this paper is to review the main causes of the crisis, to assess the role
of the IMF and the Malaysian strategies and finally to address some of the lessons
that we have learned so far from the Asian Crisis.
The Paper is organized as follows. Section two summarizes the precipitation of the
crisis. Section three reviews the main causes of the crisis. Section four provides a
brief explanation of the IMF and the Malaysian strategies to conquer the crisis, as
well as reviewing the main critiques to both strategies. And, finally, section five
comprises the conclusion, which addresses some of the lessons learned so far from
the crisis and its effect on the development of new international financial architecture.
The Precipitation of the Crisis
In the mid-year of 1997 the financial crisis that hit the Asian economies
(Asian five- Thailand, Indonesia, Malaysia, Korea and the Philippines) was
intensifying. The crisis started by the devaluation of the Thai currency "Baht" in the
summer of 1997. The devaluation of the Baht triggered a case of dramatic capital
flight from the Asian countries accompanied by turmoil in capital and money
markets, which eventually led to a slump in the domestic stock prices as well as a
devaluation of local currencies. The Asian governments tried to defend their
currencies by using the foreign reserves, but eventually the reserves were fully
depleted and the devaluation was inevitable.
In Principle, the Asian Crisis had gone through several stages before it turned to be a
complete financial and economic crisis. Nixson and Walters (1999) contended that it
was initially a linked series of currency crises, which had a domino effect on the
currencies of the Asian five, caused them to collapse significantly. Also Paul
Krugman (1998) wrote "However, the currency crises were only part of a broader
5

6. financial crisis, which had very little to do with currencies or even monetary issues
per se". As a consequence of the currency crisis investors panically withdrew out
their short-term capital to cause many bankrupts of financial institutions throughout
the region "In this sense, the Asian crisis can be understood as a 'crisis of success'
caused by a boom of international lending followed by a sudden withdrawal of
funds"4
. The occurrence of this internal financial crisis had led to a dramatic decline
in the amount of credit available to different business enterprises causing them to
went bankrupt as well.
Many countries of the region such as Thailand, South Korea Indonesia and the
Philippines, Knocked the IMF doors to conquer the crisis. However it was argued that
the IMF intervention had made the crisis worse rather than better. "This was arguably
exacerbated by the intervention of the IMF, which tied the extension of international
credit lines to the imposition of a deflationary stabilization package. This in turn
generated a further crisis; one of rising unemployment, destitution and poverty"5
.
Dissimilarly, Malaysia's Prime Minister Mahathir in September 1st 1998, decided to
adopt a "Help yourself" strategy, which aimed at ending the speculation against the
Malaysian currency "Ringgit"6
. Accordingly, the Malaysian government imposed
controls on capital outflows, and fixed the exchange rate at MR 3.8/1 US Dollar
along with maintaining an autonomous monetary policy, which allowed them to cut
interest rates without affecting the exchange rate. In fact, the primary goal of
imposing the controls was to stop the short selling of Ringgit assets in the offshore
market. Also they were aware of possible evasions that would occur, hence they
enforced a set of regulatory actions to protect their policy against these evasions.
4
The Onset of the East Asian Financial Crisis, Steven Radelet and Jeffrey Sachs (1998).
5
Nixson, F. and Walters, B(1999) "The Asian Crisis: Causes and Consequences.
6
Prime Minister Mahathir claimed that George Soros's speculation, at that time, was the key reason of
the crisis.
6

7. Apparently, the Asian crisis started as a currency crisis and, finally, turned out to be a
crisis of the real economy. In the next section I will review the causes of the crisis.
Fundamental Weaknesses and Structural Problems
• Current Account Deficits:
As mentioned above the first argument included the large and continuous trade
and current account deficits for the Asian countries as one of the causes. Table 1 lists
the current account deficit as a percentage of GDP for the most affected economies in
addition to China and Taiwan during the period from 1992 through 1997.
Country 1992 1993 1994 1995 1996 1997
Korea -1.70 -0.16 -1.45 -1.91 -4.82 -1.90
Indonesia -2.46 -0.82 -1.54 -4.27 -3.30 -3.62
Malaysia -3.39 -10.11 -6.60 -8.85 -3.73 -3.50
Philippines -3.17 -6.69 -3.74 -5.06 -4.67 -6.07
Thailand -6.23 -5.68 -6.38 -8.35 -8.51 -2.35
China 1.09 -2.19 1.16 0.08 0.52 3.61
Taiwan 4.08 3.52 3.12 3.05 4.67 3.28
Source of data Corsetti, G. Pesent, P. and Roubini, N. (1998) "What Caused The Asian Curreny and Financial Crisis?
Part I: A Macroeconomic Overview".
As argued by Nixson and Walters (1999) these deficits were eliminated by capital
inflows to the Asian countries. However, private short-term capital inflows
represented about 80% of these capital inflows. Moreover financial institutions at that
time used these short-term capital flows to finance long-term domestic projects.
Therefore, when the currency crisis had initially hit the Asian five, the sudden
reversal of the flow of short-term capital had exposed the maturity mismatch of the
Asian five economies, the case that contributed to increase the severity of the crisis.
7

8. Furthermore, Corsetti, Pesenti and Roubini (1998) stressed on current account
imbalances as being one of the main causes of the crisis. They used the US Deputy
Treasury Secretary statement in The Economist as an evidence of the significance of
current account imbalances in triggering the Asian crisis. Corsetti et al (1998) wrote,
"Lawrence Summers, the US Deputy Treasury Secretary, wrote in The Economist that
'close attention should be paid to any current account deficit in excess of 5% of GDP,
particularly if it is financed in a way that could lead to rapid reversals' By this
standard, a number of countries in our sample provided reasons for concern".
In this context and from table 1 we can observe a general deterioration of this
measure for the Asian five from 1992 to 1996, however, amazingly, this percentage
was a bit better in three of the five countries in the year of the crisis 1997 but still a
matter of concern. Corsetti et al (1998) contended that these imbalances stemmed
mainly from large trade deficits, with a relatively small role played by net factor
payments to the rest of the world, particularly in Indonesia. Also, Nixson and Walters
(1999) argued that these deficits reflected a number of interacting influences such as
the loss of competitiveness with China, which had devalued its currency by about
50%, the appreciation of the US dollar against the Yen had led to a simultaneous
appreciation of the Asian dollar-pegged currencies against the Yen, and the
stagnation of Japan during the 1990s decreased the exports from the Asian countries.
Finally, we can observe that the initial currency crisis had hit, mostly, the Asian five
which experienced high deficits during the 1990's period "In fact, as a group, the
countries that came under attack in 1997 appear to have been those with large
current account deficits throughout the 1990's; in 1997 the appreciation of the US
dollar relative to the currencies of the high-deficit countries Thailand, Malaysia,
Philippines, Korea and Indonesia reached 78%, 52%, 52%, 107% and 151%
8

9. respectively"7
. Whereas other countries currencies such as China and Taiwan had not
been hit as severely as the Asian five. Their currencies were depreciated by 2% and
18% respectively This conclusion may support the first argument that fundamental
weaknesses like current account deficits were the main reasons of the crisis
precipitation. Nevertheless, it was argued that although the imbalances in the current
accounts set the stage for the crisis, they were not big enough to trigger such a severe
crisis.
• Banking and Financial Sectors and Deregulation problems
Krugman (1999) stated that he and most economists were wrong to explain
the Asian crisis from the perspective of conventional currency-crisis models as the
Asian crisis was mainly about bad banking and its consequences. The Asian five in
the 1990s had most of the financial intermediation occurred through the banking
sector. Most of the capital inflows from international financial community were
intermediated through the countries' domestic banks to local firms. In fact, the
banking sector in the Asian region was rapidly growing in the 1990s. However, the
poorly designed regulatory and supervision systems at that time and the fight among
this deregulated banks to obtain new market shares, facilitated a case of
overborrowing, overlending and sometimes fraudulent lending. Therefore, when local
firms during the crisis went bankrupt, domestic banks experienced large financial
problems. Corsetti et al (1998 a) argued that there was evidence that Asian banking
and financial systems were very fragile, poorly supervised and poorly regulated even
before the precipitation of the crisis.
In Indonesia the lack of compliance and enforcement had led to the evasion of
banking regulations, which were in line with Basle Committee recommendations. The
central bank in Indonesia published that in April 1996, out of total of 240 banks, 41
7 "What Caused The Asian Curreny and Financial Crisis? Part I: A Macroeconomic Overview"
Corsetti, G. Pesent, P. and Roubini, N. (1998).
9

10. exceeded the legal limits of spending, 15 failed to meet the capital adequacy ratio,
and 12 licensed foreign exchange banks turned a blind eye to the rules on net
overnight positions. In Korea as contended by Corsetti et al (1998 a) the financial
system was in real danger because of the excessive lending to large traded-sector
conglomerates a number of which went bankrupt before the onset of the currency
crisis in 1997.
In Thailand the enforcement of commercial banking regulations limited the banking
lending ability, however in the 1990s subsequent to the financial liberalization, non-
banking financial intermediaries called "finance companies" emerged and did succeed
to evade these credit limits. In addition, these financial institutions expanded their
credits to the real estate and property sector, principally financed by foreign short-
term capital.
As a consequence, many of these public and private banks and non-banking financial
institutions faced huge amounts of non-performing domestic assets and short-term
foreign currency obligations. In the beginning of 1996 state-owned banks in
Indonesia faced a non-performing debt level of 17%. In Malaysia the overlending to
real estate and property sector (42.6% of total credits) drove up asset prices by about
25% in 1996, however, eventually the central bank put ceilings on lending to the
property sector and equity purchases in order to slowdown this growth in asset prices.
Nevertheless, Corsetti et al (1998 a) argued, "these actions were too little, too late"
Moral Hazard, Asset bubbles & Corruption
The second main cause of the Asian crisis, as claimed by the first group of
economists, is the existence of Moral Hazard accompanied by Corruption, resulting
in what is referred to as "Crony Capitalism". Nixson and Walters (1999) explained,
10

11. "Moral Hazard arises whenever the incentives surrounding actions are distorted by
the existence of explicit or implicit guarantees against loss". In this sense we can
deduce that there was a wide spread belief amongst creditors, in the Asian region, that
they would be bailed-out if their investments went bad. Therefore, some economists
(Nixson and Walters 1999 and Krugman 1998) claimed that the currency crises hit
economies with more exposure to the risk of self-fulfilling crisis, than had been
previously assumed. This is simply because a combination of Moral Hazard and
Corruption "Crony Capitalism" had encouraged excessive risky investments in lower-
productivity projects.
In his paper Krugman (1999) has given an example to explain the logic of moral
hazard for guaranteed intermediaries. He assumed that an owner of an intermediary
with a capital of $100 million is facing two investment scenarios. The first yields a
certain present value of $107 million, whereas the other will either yield $120 million
with a probability of 50% or $80 million also with a probability of 50%. This implies
that the expected value of this risky investment is $100 million. Krugman explained
that moral hazard in this case would induce the owner of the financial intermediary to
pursue the risky investment, even though it has lower expected profit, as he knows
that while he can capture the $20 million profit in the good state, he has nothing to
lose if the economy turned to be in the bad state. Krugman then stated, "And this
distortion of investment decisions produces a deadweight soial loss: the expected net
return on the invested capital falls from $7 million to zero". Similarly, Mckinnon and
Pill (1996) have stressed on the notion that moral hazard can lead to excessive
investment by the economy as a whole. The Chaebol in Korea and Enterprises owned
by Soharto's family in Indonesia are good examples to the case of moral hazard in the
Asian region due to the special prejudice made to such firms by governments in order
to keep their high profitability over almost a decade.
11

12. Krugman (1999), also, argued that this excessive risky lending by unregulated
financial institutions, particularly in property, had led to a sharp rise in assets prices,
which created a "Bubble" that eventually burst, precipitating the crisis. "The problem
began with financial intermediaries - institutions whose liabilities were perceived as
having an implicit government guarantee, but were essentially unregulated and
therefore subject to severe moral hazard problems. The excessive risky lending of
these institutions created inflation - not of goods but of assets prices. And then the
bubble burst"8
. Indeed the Asian five had experienced "a boom-bust cycle" in asset
prices. Krugman (1999) has developed another model in order to explain how the
willing of unregulated financial intermediaries to bid on assets drove up the prices of
assets in the Asian region, based not on their expected returns but on the Pangloss
value. The model assumed that the rent on a unit of land could be either of 25 with
probability of 2/3 or 100 with a probability of 1/3. This means that the expected
return on this piece of land equals 50 (2/3*25+1/3*100). However, an owner of
financial intermediary, induced by moral hazard, would be willing to pay 100
(Pangloss value) to acquire the land. Thus, all land will end up priced with double its
real value and owned by financial intermediaries creating what is referred to as price
bubbles. On the other hand, Radelet and Sachs (1999) argued that perhaps it is more
correct to assume that creditors at that time financed these projects as they were
expecting them to maintain their high profitability and hence the ability to repay their
loans rather than expecting a crisis and a subsequent bailout. Also, some economists
were skeptical to accept the corruption, which indeed existed in the Asian countries
as Soharto's family in Indonesia, to be one of the main reasons of the crisis. They
simply argued that corruption had existed even before the crisis and perhaps for
decades, although this did not stop the Asian economies to grow very rapidly. "If
anything, corruption in Korea was probably worse in the mid-1980s than the mid-
1990s, and yet it did not face a similar crisis at that time"9
. Finally, they concluded
8
"What Happened To Asia?” Krugman P. (1998)
9
"What Have We Learned, So Far, From the Asian Financial Crisis?" Radelet, S and Sachs, J. (1999).
12

13. that crony capitalism, indeed, was one of the factors that set the stage for the crisis
but it was not the main cause of a crisis with such magnitude and harshness. Perhaps
this becomes more evident if we review Krugman’s (1999) recent analysis, which
included an opposite argument to his former one in explaining the causes of the crisis.
Actually, Krugman’s recent argument put the financial panic, the over-liberalized
international and domestic financial systems, and the lack of banking supervision in
the heart of the crisis.
Nixson and Walters (1999) argued that Moral Hazard provided a mechanism to bond
the characteristics of the Asian crisis to the first- and second-generation currency
crisis models (models developed by Krugman 1979; Flood and Garber 1984; Obstfeld
1995) used to explain financial turmoil in emerging countries. In his explanation of
the first-generation crisis model, Krugman (1999) mentioned that a government with
persistent budget deficit financed by money creation was assumed to use its limited
stock of reserves to maintain a pegged exchange rate. This policy would be,
eventually, unsustainable due to inflationary pressures and depletion of reserves,
leading to loss of investors' confidence and generating a speculative attack on the
currency, especially when the reserves fell to some crucial point. While, the second-
generation models assume that governments have the choice to maintain a policy of
pegged exchange rates or not, taking into consideration the effect of the monetary
policy on economic growth. Indeed, from the first sight it is obvious that these
models cannot provide an explanation of the initial Asian currency crisis. Nixson and
Walters (1999) contended, "The Asian economies were in rough fiscal balance, credit
creation was not excessive and inflation was generally under control". However, as
argued by Nixson and Walters (1999) Moral Hazard, provided the tool to link the
Asian crisis to these models. Moral Hazard had induced foreign investors to lend
domestic financial institutions on the basis of implicit governmental guarantees. This
had encouraged excessively risky investments in low productive projects leading to
increased levels of inflation. Also, it implied an increase in governmental debts in the
13

14. future if these guarantees need to be realized. Therefore, a deterioration of the
governments' future fiscal position can be anticipated.
However, it was recently contended (Radelet and Sachs 1998, Krugman 1999, and
Nixson and Walters 1999) that these arguments based on fundamental weaknesses,
structural problems and Moral hazard did not provide a sufficient explanation for the
causes of the crisis. They cited four main reasons for their argument listed as follows.
First, they stated that it is difficult to identify the crisis countries as experiencing
fundamental macroeconomic disequilibria. Second, the harshness of the fall in the
exchange rates was extremely more than enough to eliminate the deficits in the
current accounts. Third, the size of the bubble sectors was relatively small. Finally,
the contagion of the crisis from the countries of Southeast Asia to Korea in the North,
even though Korea had enjoyed a long period of strong real economy and the relative
lack of integration with other afflicted countries. Therefore, another explanations
were emerged in recent years trying to solve the paradoxes existed in the earlier
explanations such as the financial panic argument.
Financial Panic
It has been argued recently, among others, by Radelet and Sachs (1998) that
the main cause of the Asian crisis was the panicky outflows of capital rather than
fundamental macroeconomic weaknesses. In fact Sachs stated, "There is no
fundamental reason for Asia's financial calamity except financial panic itself. Asia's
need for significant financial sector reform is real, but not a sufficient cause for the
panic, and not a justification for harsh macroeconomic policy adjustments, Asia's
fundamentals are adequate to forestall an economic contraction: budgets are in
balance or surplus, inflation is low, private saving rates are high, economies are
poised for export growth. Asia is not reeling from a crisis of fundamentals but a self-
fulfilling withdrawal of short-term loans, one is that fuelled by each investor's
14

15. recognition that all other investors are withdrawing their claims. Since short-term
debts exceed foreign exchange reserves, it is rational for each investor to join in the
panic."10
.
Financial panic as defined by Dybvig-Diamond (1983), in their model of a bank run,
is a case of multiple equilibria in the financial markets. Also, defined by Radelet and
Sachs (1998) as an adverse equilibrium result in which sudden withdrawals of short-
term loans from a solvent borrower occurs, In fact, Radelet and Sachs (1998) cited
two main reasons for financial panic: short-term liabilities exceed short-term assets
and the absence of lender-of-last-resort. The best example for the success of lender-
of-last-resort operations to overcome a crisis is, perhaps, the Mexican case. In early
1995 after the devaluation of the Mexican peso, the government could not rollover its
short-term debts. Therefore, the IMF and the United States, to provide Mexico with
about $50 billion to repay their debts, established a lender-of-last-resort jointly. In
fact, this action helped the Mexican government to prevent default and to restore its
economic growth in the subsequent year. However, it was argued that if the crisis is a
result of a bubble burst or a moral hazard end, then it is more appropriate to avoid the
lender-of-last-resort, as it will maintain the unproductive investments alive.
Therefore, it was concluded that the existence of the lender-of-last-resort is essential
only if the panic induced investors to suddenly withdraw their credit lines when it is
not necessary to do so.
Radelet and Sachs (1998) contended that the only reason that economists did not
attribute the causes of the Asian crisis to panic simply because economists always
pursue more sophisticated explanations for financial crises. "Financial panic is rarely
the favored interpretation of a financial crisis. The essence of a panic is that a 'bad'
10
Sachs, quoted in Nixson and Walters, 1999, pp. 507
15

16. equilibrium occurs that did not have to happen. Market analysts and participants are
much more prone to look for weightier explanations than simply a bad accident"11
.
As a matter of fact, the advocates of the financial panic argument did not deny the
existence of some fundamental and structural problems in the Asian economies. But it
is also true that they did not accept these problems as the main causes of the crisis.
Radelet and Sachs (1998) reconstructed the crisis in the context of the following
scenario, to make it evident that the Asian crisis was triggered by financial panic,
disorderly workout and policy mistakes. The scenario started with panicky
withdrawal of short-term capital from the Asian region. As a consequence the
maturity mismatch of the banking sector had been exposed resulting in liquidity
problems and a surge in interest rates. Thus, even previously profitable and
productive firms found it very hard to both obtain working capital and survive these
high interest rates. Furthermore, offshore creditors, to protect their clients' money,
declined to rollover short-term loans. In this panicky environment banks found it very
difficult to keep their minimum capital adequacy standards. Also, panicky domestic
depositors exacerbated the liquidity problem by claiming their funds from banks,
putting the whole banking sector under further pressures. Additionally, it was
contended that the policy mistakes committed by the Asian governments at that time
contributed to the crisis precipitation. "Had Thailand responded to the fall in property
prices in early 1997 by floating the baht and moderately tightening monetary and
fiscal policies, the Asian financial crisis could have been largely avoided. Thailand
and Korea, of course, made the paramount mistake of trying to defend their exchange
rate peg until they had effectively exhausted a substantial proportion of their foreign
reserves"12
.
11
The Onset of the East Asian Financial Crisis, Steven Radelet and Jeffrey Sachs (1998).
12
The Onset of the East Asian Financial Crisis, Steven Radelet and Jeffrey Sachs (1998).
16

17. In fact Radelet and Sachs (1998) have given two main reasons for the dominance of
the financial panic argument. First, the crisis hit countries with the highest ratios of
short-term foreign debts relative to short-term assets. Second, the severity of the crisis
was highly decreased one year later, although many of the fundamental weaknesses
were not substantially eliminated.
Political Instability and Policy Mistakes
One of the main causes of the crisis as contended by most of the economists,
was the political instability of the Asian countries at the time of the crisis. In fact,
political instability may affect the level of cash inflows, to a certain country, from the
international financial community. Corsetti et al (1998 b) contended that the
deterioration in expectations about the political environment in any country can have
negative effects on this country's balance of payment, exchange rate and eventually
may contribute to larger budget deficits.
In this context, if we visit the Asian five during the days of the crisis, we will find
that there were some tensions accompanying the elections in Indonesia besides the
uncertainty of the news about the health status of Soharto at that time. In Malaysia,
Mahathir claims against "rouge speculators", the government collapse in Thailand
and the presidential election in Korea contributed, indeed, to the precipitation of the
capital flight and eventually the full-fledged crisis.
In addition, although the Asian governments did sign agreements with the IMF, they
did not take the implementation of this early-stage IMF measures seriously,
regardless whether or not they were suitable for the Asian case. This added more
clouds on the uncertainty surrounded the governments’ intentions to conquer the
crisis. "Regardless of whether the initial IMF plans were appropriate, it is clear that
governments failed to enforce even the most sensible components of such plans. In
17

18. Indonesia, a corrupt and authoritarian regime effectively ignored most of its agreed-
upon commitments until the severe deterioration of macro conditions led to a fully
fledged collapse and the free fall of the rupiah. For the case of Korea, there were
serious doubts about the implementation of the first IMF plan, given the coming
elections in December and the broad policy uncertainty associated with the event. In
Thailand, it was only with a new government truly committed to economic reforms
that the value of the baht stabilized, and even appreciated relative to the lows
reached in December"13
.
The IMF Role
At the onset of the crisis the Asian governments, except the Malaysian, found
it essential to get the assistance of the IMF in order to overcome the 'bad days'. In
fact, many commentators criticized the IMF intervention to the extent that it was
argued that the IMF exacerbated the deepness of the crisis. It was also argued that the
IMF measures increased the financial panic at the midst of the crisis.
On the other hand the IMF's managing director. Michel Camdessus advocated the
Fund's intervention as follows, "As soon as it was called upon, the IMF moved
quickly to help Thailand, then Indonesia, and then Korea formulate reform programs
aimed at tackling the roots of their problems and restoring investor confidence. In
view of the nature of the crisis, these programs had to go far beyond addressing the
major fiscal, monetary, or external balances. Their aim is to strengthen financial
systems, improve governance and transparency, restore economic competitiveness,
and modernize the legal and regulatory environment”14
. Before further reviewing
13 "What Caused The Asian Curreny and Financial Crisis? Part I: A Macroeconomic Overview"
Corsetti, G. Pesent, P. and Roubini, N. (1998).
14
"What Caused The Asian Curreny and Financial Crisis? Part II: A Policy Debate" Corsetti, G.
Pesent, P. and Roubini, N. (1998).
18

19. either the critiques or the advocates of the IMF intervention, it is useful to summarize
the Fund's programs in the coming few lines.
In response to the precipitation of the crisis the IMF approved large standby credits
for the afflicted countries. However, it was contended by Radelet and Sachs (1998)
that the actual credit granted for such countries was far smaller. The IMF had
approved $17.2 billions, $40 billions and $57 billions packages for Thailand,
Indonesia and Korea respectively. In fact, these rescue-packages were conditional
upon the acceptance of some measures formulated by the Fund. These measures
included, principally, fiscal contraction policy, bank closures, tight monetary policy
and the imposition of structural reform programs for both the financial and
commercial systems. The fiscal contraction aimed at helping the governments to
maintain a tight monetary policy, and thus, protecting the currencies against further
depreciation. Bank closures and the enforcement of capital adequacy standards aimed
at limiting the losses carried by unviable banks as well as signaling the seriousness of
the governments to carry on the reform programs. Additionally, the reforms programs
mainly for the commercial framework aimed at setting the stage for a better business
environment.
It was argued that these measures reflected the IMF's diagnosis of the crisis, which
apparently, assumed that the existence of fundamental weaknesses and structural
problems in the Asian economies is the main cause of the crisis. Also, Nixson and
Walters (1999) pointed out that the IMF's goals of raising the interest rates, restoring
current account equilibrium, and starting a structural reforms of the financial and
commercial systems would reflect sufficient signals of the Asian governments' 'bona
fides' to restore confidence and capital inflows. In fact these early-stage programs
failed to achieve the goals and, additionally, none of them ended in its original form
for more than few weeks. Therefore, new agreements were signed with Thailand,
Korea and Indonesia. Furthermore, Nixson and Walters (1999) pointed out that it is
19

20. clear that the IMF's initial measures failed to meet its objectives of stabilizing
exchange rates and restoring capital inflows.
In fact economists cited so many reasons for the IMF's unsuccessfulness. Radelet and
Sachs (1998) stated, " But there are several reasons to believe that the underlying
design of programs added to, rather than ameliorated, the panic". It was argued that
there are three main reasons can be attributed to the fail of these initial programs.
First, the bank closures decision was heavily criticized by some economists as it,
arguably, added to the financial panic and induced a case of bank-run at the midst of
the crisis. Sachs (1998) stated, "In my view, although it's a minority opinion, the IMF
did a lot of confidence-reducing measures. In particular, I blame the IMF for
abruptly closing financial institutions throughout Asia, sending a remarkably abrupt,
unprepared and dangerous signal /...../ that you had better take your money out or
you might lose it"15
. In addition Radelet and Sachs (1998) argued that it was much
better to implement a more comprehensive strategies for bank restructuring over a
longer time horizon, instead of this "quick show of force designed simply to
demonstrate resolve". And they cited the massive Indonesian bank's run as evidence
supporting their argument.
On the other hand Corsetti et al (1998 b) pointed out that other economists advocated
the implementation of this measure, as some banks were in "bad shape", and
supported their views by the fact that the banks closures program was imposed in
Indonesia along with Thailand and Korea, however, neither country experienced
banks runs of the same magnitude as those hit Indonesia.
Second, many analysts had questioned the appropriateness of the tight monetary
policy imposed in the crises countries. In fact it was argued that raising interest rates
during a financial crisis would cause a further deterioration in the exchange rate
15
Jeffrey Sachs, an interview in Asia week, Feb. 1998 quoted in Corsetti et al (1998 b)
20

21. rather than improving it. "Tight money in a given financial center can serve either to
attract funds or repel them, depending on expectations that a rise in interest rates
generates. With inelastic expectations -- no fear of crisis or currency depreciation--
an increase in the discount rate attracts funds from abroad, and helps to provide the
cash needed to ensure liquidity; with elastic expectations of change-- of falling
prices, bankruptcies, or exchange depreciation-- raising the discount rate may
suggest to foreigners the need to take more funds out rather than bring new funds
in16
". As a matter of fact, high interest rates in the Asian crisis did not help to
maintain the Asian currencies' values, on contrary, exchange rates continued to
plunge after the signing of the IMF programs. Supporting this argument, Corsetti et al
(1998 b) contended that the appropriate policy response to the crisis should have been
one of loose money and low interest rates. On the other hand, it was argued that a
policy of loose money would induce further currency depreciation, and hence, raising
the value of banks' foreign currency denominated obligations. Finally, Corsetti et al
(1998 b) concluded, "While the appropriate interest rate policy at the onset of the
crisis is still subject to a wide spread debate, at the time of this writing -- and in the
light of the large recessions experienced by the Asian economies in 1998 -- most
observers sum to agree that high interest rates maintained beyond an emergency
scenario can have destabilizing consequences".
In the recognition of its advantages and disadvantages, many analysts questioned
whether the tight monetary policy's benefits had outweighed its costs in the Asian
economies during the crisis. The IMF announced early that they are self confident
that the benefits will be far higher than the costs. Subsequently, Furman and Stiglitz
(1998) expressed their concerns that the high interest rates had worsened the crisis
rather than easing it up. They proved that not only the high interest rates didn't help to
maintain the exchange rates but also local banks and business entities had paid a very
expensive price for the policy. In the mean time Radelet and Sachs (1999)
16
Kindleberger (1978) quoted in Radelet and Sachs (1998).
21

22. summarized the debate in the following words' "Finally, while sustained high interest
rates may have contributed to the eventual strengthening of these currencies, that by
itself does not justify the policy, since the costs to banks and firms were very high,
and the interest rate policy may have helped to trigger the panic in the first place.".
Third, it was argued that the deflationary fiscal program imposed in the crises
countries was unnecessarily and harmfully strict. "The fund initially demanded a
fiscal surplus of 1 per cent of GDP in each country. It is not clear why government
budgets were made so central to the programs, since fiscal policy had been fairly
prudent across the region,, and budget profligacy was clearly not the source of the
crisis" Radelet and Sachs (1998). On the other hand Corsetti et al (1998 b) pointed
out that some commentators argued that loose fiscal policy at the onset of the crisis
would have been a matter of concern among investors that policy makers are not
sufficiently committed to reduce current account imbalances.
Finally Nixson and Walters (1999) noted that this severe criticism of the IMF's role in
handling the Asian crisis stemmed mainly from the emergence of alternative
diagnoses of the central problem triggered the crisis. These alternative diagnoses
included the instability of international capital markets and financial panic as the
central contributory factors in the crisis. Therefore, the advocates of these diagnoses
proposed another measures in response to the Asian crisis.
Malaysian Help yourself Policy
In the year of 1998 the financial crisis that hit Malaysia, along with other
countries in the Southeast Asia region was intensifying. Many countries of the region
knocked the IMF doors to conquer the crisis such as Thailand and South Korea.
Dissimilarly, Malaysia’s Prime Minister Mahathir in September 1st
1999, decided to
adopt a “help your self” strategy, which aimed at ending the speculation against the
Malaysian currency “Ringgit”. Accordingly, the Malaysian government imposed
22

23. controls on capital outflows, and fixed the exchange rate at MR 3.8/1 Dollar along
with maintaining an autonomous monetary policy, which allowed them to cut interest
rates without affecting the exchange rate.
It was argued by Sebastian Edwards (1999)17
that one of core problems that triggered
the 1990’s financial crisis the free mobility of capital to and from countries hit by the
crisis. Also, it was argued that it is not possible for any country to maintain free
capital flows and policy of fixed exchange rate without using its monetary policy just
for this reason. Perhaps this become more obvious, if we use McKinnon and Oates
words “no government can maintain fixed-exchange rates, free capital mobility, and
have an independent monetary policy, one of the three options must give”.
Furthermore, this is referred to, as argued by Obstfeld and Taylor 1998, as
“incompatible trinity or the trilemma”18
.
From above we can appreciate the merits of using capital controls in helping
governments in implementing both fixed exchange rates and independent monetary
policies, similarly to what happened in Malaysia. In fact maintaining fixed-exchange
rates, and autonomous monetary policy are not the goals by themselves, however,
they help governments to achieve their real objective of overcoming financial crisis,
without increasing the unemployment rates or slowing down the economy.
Furthermore, they help governments to prevent the occurrence of “balance of
payment crisis” through correcting any balance of payments deficit. “Thus, capital
controls are sometimes described in terms of the choices they avoid: to prevent
capital outflows that, through their effect on the balance of payments, might either
endanger fixed-exchange rates or independence of monetary policy”19
However, there are some drawbacks of limiting free capital mobility among
countries. The most important drawback as contended by Christopher J. Neely is
limiting the benefits of capital flows, which are represented in facilitating,
consumption patterns; technology transfer; and portfolio diversification. Another
drawback is the possibility of evading capital controls either on inflows or outflows,
simply by over or under pricing invoices. Furthermore, controls can be avoided either
17
The mirage of capital controls, Sebastian Edwards, May 1999.
18
An introduction to capital controls. Christopher J. Neely
19
An introduction to capital controls. Christopher J. Neely
23

24. by delaying or speeding up payments to foreign suppliers – known as “leads and
lags” 20
. Avoidance of such controls will consequently impair the effectiveness and
deteriorate the system. If government turns a blind eye to this evading, the existence
of controls will lead to a “false sense of security”21
. In addition, imposing capital
controls might lead to lack of confidence of investors in the domestic economy.
Did Capital Controls work?
In fact the answer to this question is quite controversial. On one extreme some
economists supported the notion of the inefficiency of capital controls and argued that
they may harm the successfulness of a country’s economy, “The consensus among
economists has been that capital controls—like tariffs on goods—are obviously
detrimental to economic efficiency because they prevent productive resources from
being used where they are most needed.”22
. Moreover they contended that capital
controls did not help in recovering from the 1980’s debt crisis, “Those Latin
American countries that stepped-up controls on capital outflows – Argentina, Brazil
and Mexico, to mention just the largest ones– muddled through, and experienced a
long and painful decline in growth, high inflation and rampant unemployment”23
.
At the other extreme, others highly supported the use of capital controls, in addition
they argued that capital controls could be considered to be efficient tools to overcome
financial crisis, similarly to what happened in Malaysia in 1998. “Malaysia recovered
from the Asian financial crisis swiftly after the imposition of capital controls in
September 1998. Compared to IMF programs, we find that the Malaysian policies
produced faster economic recovery, smaller declines in employment and real wages,
and more rapid turnaround in the stock market”24
.
And in the middle of the road there is a group who contended that although capital
controls cannot be considered as successful tools to overcome the financial crisis,
they indeed give governments the sufficient time to undertake reform procedures in
order to overcome their problems. “Even economists who oppose capital controls
20
Einzing, Paul. Leads and Lags, MacMillan and company, 1968.
21
The mirage of capital controls, Sebastian Edwards, May 1999.
22
An introduction to capital controls. Christopher J. Neely
23
The mirage of capital controls, Sebastian Edwards, May 1999.
24
Did the Malaysian capital controls work?, Ethan Kaplan and Dani Rodrik.
24

25. believe that they may have been of some use in buying time to implement fundamental
reforms”25
.
In fact, the Malaysian business community at that time was happy with the economic
stability resulted from adopting such policies. But on the other hand the middle-of-
the-road group who claimed that “buying time for reform” is the only benefit of
imposing capital controls, was concerned that government did not undertake real
economic-reform procedures, the case which may ultimately worsen the situation
rather than improving it. “Others fear, however, that the capital controls have
replaced reform, rather than buying time for reform. As of May 1999, the Malaysian
government does not appear to be using the breathing space purchased by the capital
controls to make fundamental adjustments to its fragile and highly leveraged
financial sector. Rather, Prime Minister Mahathir has sacked policymakers who
advocate reform while aggressively lowering interest rates, loosening nonperforming
loan classification regulation and setting minimum lending targets for banks”26
.
Kaplan and Rodrick asked, “Did the Malaysian gamble pay off”, I think that the
answer to this question is, obviously “Yes” they managed to recover from the
financial crisis. However, I think that this leads to a more important question of “Did
this recovery was a direct result of imposing capital controls”. The answer to this
question is quite simple: “Yes”, but we should take into consideration that the main
reason for imposing such controls was to cut the speculation against the Malaysian
ringgit at that time. In other words, I think that Malaysian experience suggests that
capital controls worked efficiently to cut the speculation against its currency,
however, they would not have worked effectively if the Malaysian crisis was more
severe, like in other countries.
Conclusion
The Asian financial crisis, apparently, had increased economists' demand for
the development of new international financial architecture. One that would help to
25
An introduction to capital controls. Christopher J. Neely
26
An introduction to capital controls, Christopher J. Neely.
25

26. minimize the possibility of a new crisis with such magnitude and effect and even if it
occurs the new architecture should help to overcome the crisis in a more elegant
manner than happened in the Asian crisis. The Asian crisis induced many analysts to
cast some doubts about the suitability of rapidly liberalizing emerging markets. It was
argued that the rapid financial liberalization of the Asian economies in the early
1990s did not enable policy makers to put sufficient regulatory and supervision
systems in place, and therefore, made them more crisis prone than other emerging
markets with slower liberalizing steps. In fact, the lack of a robust regulatory system
led to a massive short-term lending from abroad by domestic banks without taking
into consideration the high vulnerability of such short-term capital inflows to large
reversals, the case that exposed the whole region during the crisis. Radelet and Sachs
(1999) argued that short-term cross-border debt flows should be the last item on the
liberalization list, since they are highly vulnerable to volatility and Panic. Similarly
Fischer (1999) argued that although there is no need to have controls on longer term
capital inflows, it is preferable for emerging markets to have market-based controls
on short-term capital. Actually, both authors had cast the Chilean and Malaysian
cases as evidence supporting their arguments. "Many analysts attribute Chile's ability
to avoid financial crises in the wake of the panics in Mexico, Argentina and Asia to
these restrictions and Chile's small stock of short-term foreign debt"27
. However,
Fischer returned to argue that these controls either on capital inflows or outflows
should be for a short time period "While it may be tempting to impose capital outflow
controls to deal with short-term crisis, as Malaysia did in 1998, the longer-term
consequences are likely to be adverse"28
. In addition, it was recommended that
emerging markets should start to build strong domestic banking and financial
systems. Furthermore Fischer (1999) argued that it is not only regulations and
supervision that are needed to modernize banking sector in emerging markets, but
also competition, particularly, foreign competition is an essential element.
27
What Have we Learned So Far from The Asian Financial Crisis? Steven Radelet and Jeffery Sachs
(1999).
28
Reforming the International Financial System. Stanley Fischer (1999).
26

27. Another fact has been unearthed from the unfolded crisis that the fixed exchange rate
policy is very dangerous to adopt as it may lead to complete depletion of the reserves
and eventually a huge depreciation. Indeed fixed exchange rates had been advocated,
for decades, for being able to reduce volatility of currencies. However, the facts from
the Asian crisis made it clear that they are more vulnerable to extensive devaluations
when they cannot be protected anymore. Accordingly, many economists
recommended the use of more flexible exchange rates by emerging markets in the
new financial architecture.
Moreover, it was argued that the Asian crisis had shown the importance of
establishing efficient systems in emerging markets to provide complete and fully
transparent information. This information should cover the government's activities,
country's policies, the state of the economy as well as covering private firms
activities. Also, the need of clear and strong corporate finance and governance
including efficient bankruptcy laws was made clear by many economists in the wake
of the crisis.
Finally many arguments have been made to emphasize the role of International
Financial Institutions in helping countries to effectively implement reform programs
to improve both their economies and the quality of international capital flows. In fact,
Fischer (1999) has briefly listed the elements of a new financial architecture, in the
wake of the Asian crisis, as follows:
"In particular work is on going (i) to strengthen financial systems and economic
policies by encouraging the design and adoption of banking and other relevant
standards; (ii) to encourage the provision of better information to the markets and to
the public more generally; (iii) to improve surveillance of economic and financial
developments and policies: and (iv) to consider changes in IFI (International
Financial Institutions) lending practices".
27

28. Bibliography
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to the IMF-Bundesbank Symposium, Frankfurt, Germany.
• Corsetti G., Pesenti P. and Roubini N. (1998) “What Caused The Asian
Currency and Financial Crisis? Part I: A Macroeconomic Overview”
http://www.stern.nyu.edu/~nroubini/asia.
• Corsetti G., Pesenti P. and Roubini N. (1998) “What Caused The Asian
Currency and Financial Crisis? Part I: A Policy Debate”
http://www.stern.nyu.edu/~nroubini/asia.
• Corsetti G., Pesenti P. and Roubini N. (1998) “Paper Tigers? A model of the
Asian Crisis” http://www.stern.nyu.edu/~nroubini/asia.
• Edwards S. (1999) “The Mirage of Capital Controls”.
• Eichengreen B. (1998) “International Economic Policy in the Wake of the
Asian Crisis”.
• Eichengreen B. (1999) “International Monetary Fund in the Wake of the
Asian Crisis”.
• Einzing, Paul, Leads and Lags, MackMillan and Company ,1968.
• Fischer S. (1999) “Reforming the International Financial System”.
• Furman J. and Stiglitz J. (1998) “Economic Crisis: Evidence and Insights
from East Asia”.
• Kaplan E. and Rodrick D. (1998) “Did the Malaysian Capital Controls
Work?”.
• Krugman P. and Obstfeld M. “International Economics” 5th
edition, Adisson
Wesley (2000).
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http://web.mit.edu/krugman/www/DISINTER/html.
• McNeill, D and Bockman H. (1998) “Introduction to View Points on the Asian
Financial Crisis” World Development, Vol.26, No. 8, August.
• Neely, Christopher J. “An Introduction to Capital Controls”.
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Consequences”
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Crisis”.
28

29. • Radelet S. and Sachs J. (1999) “What Have We Learned, So Far, From the
Asian Financial Crisis?”.
• Sachs J. (1997) “The Wrong Medicine for Asia” The New York Times.
29