This article first appeared in Forum, The Edge Malaysia Weekly on August 1, 2022 - August 7, 2022

Exactly 25 years ago last month, East Asia went through its worst financial crisis. Several countries, particularly Malaysia, Thailand, Indonesia, South Korea and the Philippines, were hit. What began as a speculative attack on the baht in July 1997, quickly spread like a contagion to the other countries. 

Over the three-month period from July to October 1997, the baht fell 40%, the ringgit and Philippine peso by about 27%, the rupiah by about 40% and the won 35%, against the US dollar. 

This was a serious blow for countries that have been dubbed “miracle economies”. The currency crisis quickly metamorphosed into what economists called “a twin crisis”. In essence, slumping currencies and the policy response of defending them through rate hikes set off a domestic banking crisis. This happened across four countries — South Korea, Thailand, Indonesia and Malaysia.

Interestingly, average nominal GDP growth for the four countries over the seven-year period preceding the crisis had exceeded 12% per year. So, compounded, each country had more than doubled its GDP in 1996 from 1990 levels, hence the International Monetary Fund’s glowing term “miracle economies”. But such growth was simply not sustainable, having been primed by rapid monetary growth, large current account deficits and capital inflows, especially of the short-term variety. 

Several alternative explanations were put forth to explain the crises. Broadly speaking, there were three: (i) The existence of structural weaknesses and policy distortions, that is, very high levels of foreign currency-denominated debt based on variable interest rates, sharp reductions in foreign direct investment inflows and overvalued exchange rates. Since the exchange rate regimes were largely pegged or quasi-pegged at government determined rates, overvaluations were purely policy induced distortions; (ii) Moral hazard arising from a combination of informational asymmetries, implicit guarantees and lack of transparency. The existence of politico-business links accentuated adverse selection problems, making the underlying economies vulnerable. These vulnerabilities remained masked until unravelled by the crisis; (iii) Reversal of capital flows and the resulting illiquidity. 

When there is rapid build-up in short-term external debt, a crisis can be triggered when a country’s ability to service outstanding short-term debt appears questionable. If large gaps exist in the stock of liquid financial assets and gross reserves in the presence of a pegged exchange rate, vulnerability builds. Given such imbalances, a sudden shock can quickly drain reserves, making the fixed exchange rate unsustainable.

For policymakers, the crisis had been an eye opener. It taught them many lessons and, more importantly, provided them the opportunity to undertake the reforms they knew were needed but resisted by the ruling political elite. 

A first lesson learnt was that transparency and good disclosure was the best antidote against speculative attacks, which fed on opaqueness and informational gaps. The post-crisis period saw the production and release of timely relevant information, especially on banking and finance. 

A second key lesson learnt was that pegged exchange rates are incompatible and can be highly dangerous for developing economies as they invariably lead to currency mismatches and incentivise firms to take unhedged positions. Post-crisis, there was a switch from pegs to managed floats.

A third lesson learnt was that debt-funded growth is superficial, unsustainable and crisis-prone. The mantra of growth at all costs was dropped as the crisis showed how ruinous and costly vulnerability to external shocks can be when an economy is highly leveraged. 

A final key lesson learnt was the need to check excessive risk-taking by economic agents, driven by ebullience, greed and the moral hazard of being able to externalise the risks taken, effectively socialising the risks through implicit guarantees and explicit bailouts. As these lessons dawned on policymakers, tighter controls and prudential regulations were introduced, and banks were recapitalised, consolidated and strengthened. Capital markets were developed to move away from inherently unstable bank concentric systems.

A lot of good did indeed arise from the lessons learnt from the crisis. Evaluating the post-crisis years, some countries like South Korea and Indonesia, perhaps due to the huge political and human costs incurred, have been more faithful to the reforms, while others like Malaysia are less so. 

Given the current state of affairs, it appears that some important lessons are yet to be learnt. A first lesson not learnt is of the dangers of debt accumulation, regardless of sector. With years of easy money and repressed interest rates, acceptable levels of gearing and leverage thresholds have been allowed to rise. 

Certain sectors in Malaysia, households, for example, have accumulated huge levels of debt. The reported numbers may not even include peer-to-peer and other informal debt. Thus, the overhang could be larger than the numbers suggest. Further, what is often overlooked is that when institutions are weak and faulty because they are malleable, resilience is compromised even at low levels of debt. 

As such, debt-to-gross-domestic-product ratios may not necessarily reflect true vulnerability. Case in point, Sri Lanka’s debt-to-GDP in 2021 was lower than those of Singapore and Japan for the same year. More than debt ratios, institutional independence and strength is the key.

A second important lesson not learnt is that good governance requires that politics and business should not be allowed to mix. The many accusations during the crisis of crony capitalism being at the root of Malaysia’s problems appear not to have been taken seriously. 

Thus, not surprisingly, Malaysia’s worst and most outrageous abuses and financial scandals have happened post-crisis. This is clear testimony to the superficiality of reforms undertaken. When board and leadership positions in GLCs are seen as trophies to be used for political gains, good governance cannot be expected.

A final important lesson not learnt is that the mere adoption of rules and regulations, even those based on international best practices, is not enough if enforcement/execution is lacking. 

As the many recent scandals have shown, it wasn’t the lack of regulation but inadequate oversight and enforcement that made them possible. On too many occasions, key regulators have been caught napping. 

Yet, there appears to be no mechanism nor will to bring these regulators to book. It is these gaps in enforcement and regulatory failures that could set us up for the next fall.

Dr Obiyathulla Ismath Bacha is professor of finance at INCEIF University

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