The Perils of Pegged Exchange

Rates: A Comparative Study on

the Tequila Effect and the Asian
Contagion
Abstract: The peso crisis in Mexico in 1994 and the Asian financial crisis that occurred in 1997-
1998 were two of the most significant financial crises that occurred in emerging nations
throughout the 1990s. This paper takes a comparative framework to explore the root causes,
recovery tactics that were used, and the part that the International Monetary Fund (IMF) played
in each of the occurrences. This shows how different levels of contagion require different policy
responses by comparing the Mexican crisis, (which affected an area about a quarter the size and
population of the Asian crisis), to the Asian crisis. By using a comparative perspective, we hope
to draw important conclusions and highlight the critical role those strong institutions and
economic policies play in preventing similar financial shocks in the future.
Introduction:
In the late 20th century, the global economy experienced two significant financial crises that
fundamentally changed how stability was perceived and revealed the complex ties in
international finance. An abrupt devaluation of the peso in Mexico contributed to the beginning
of the Tequila Crisis in 1994. This crisis marked the beginning of the crisis. The nation was
pushed into a severe recession due to an excessive amount of debt, along with high interest rates
and political instability. This resulted in widespread bank failures and economic upheaval. Not
long afterward, the Asian Financial Crisis of 1997–1998 began in Thailand, quickly engulfing
surrounding countries. Its effects spread throughout the region and beyond. These two crises
pointed out the clear problems of the dangers of economic mismanagement and the vulnerability
of developing nations, that might occur even with good economic indicators.
The 1994 Mexican Currency Crisis (The Tequila Effect)
Background:
Within the year 1994, Mexico experienced a major financial emergency regularly alluded to as
the Tequila Emergency or the Mexican Peso Emergency. This occasion was activated by a
sudden cheapening of the Mexican peso against the US dollar. This devaluation essentially
diminished the peso's esteem and started a domino impact of monetary turmoil. A few
components contributed to this emergency. The Mexican government had been investing more
than it was collecting in income, driving a noteworthy sum of national obligations. In an
endeavor to pull in the outside venture, the government advertised tall intrigue rates on short-
term obligation rebellious named in pesos. Whereas this at first pulled in speculators, it too made
the peso an unsafe speculation. Moreover, the death of a driving presidential candidate advances
disintegrated financial specialist certainty in Mexico's political steadiness. The depreciation of
the peso had extreme results. Mexico's economy dove into subsidence, meaning it's by and large
yield of merchandise and administrations contracted. Citizens confronted an unforgiving reality
as expansion, a common rise in costs, skyrocketed. The monetary segment was especially hard
hit, with numerous Mexican banks collapsing beneath the weight of the emergency. The Tequila
Emergency serves as a stark update of the vulnerabilities associated with capital flight, where
remote financial specialists pull back their cash from a nation in huge sums, and the threats of
financial fumble.
The Situation of the Mexico Crisis:
Mexico confronted a major financial emergency in 1994, known as the Tequila Emergency. It all
began with the Mexican peso. The government, strapped for cash, had been investing more than
it earned, driving to tall obligation. To pull in outside financial specialists, they advertised super
tall intrigued rates on short-term advances. This at first worked, but it was a bet. Things took a
turn for the more awful when a key political figure was killed. Speculators froze, dreading
flimsiness, and began pulling their cash out of Mexico. With everybody surging to urge out, the
peso's esteem dove. This depreciation was the "Tequila shot" that activated the emergency. The
results were brutal. Mexico's economy nosedived into subsidence, meaning businesses battled
and individuals misplaced occupations. On the off chance that that wasn't sufficient, costs were
taken off due to expansion, making it difficult for regular Mexicans to manage fundamental
necessities. The managing an account framework too disintegrated beneath the weight. The
Tequila Emergency got to be a cautionary story almost the threats of unsafe borrowing, capital
flight, and financial fumble.
What triggered the crisis:
The 1994 Mexican peso emergency, also known as the Tequila Emergency, wasn't caused by a
single occasion, but maybe an idealize storm of financial vulnerabilities. Here's the breakdown:
1. High Debt: Mexico's government had been investing more than it was taking in a few
times, driving to a noteworthy sum of national obligations. This made speculators
apprehensive approximately the country's capacity to reimburse its advances.

2. Risky Borrowing: To draw in remote ventures, Mexico advertised exceptionally tall

intrigued rates on short-term credits. Whereas this at first brought in cash, it moreover
made the peso an awfully unsafe speculation. Speculators were wagering on Mexico's
soundness, and if that soundness faltered, they seemed to lose a part of their cash.
 3. Political Instability: The death of a driving presidential candidate in 1994 smashed
financial specialist certainty. This political instability spooked financial specialists who
stressed approximately Mexico's future financial and political course. This activated a
freeze, as financial specialists hurried to pull back their cash from Mexico, causing the
peso's esteem to fall. This sudden cheapening is what touched off the emergency.

Other Countries' Role in Capital Account Investment during the Mexico Crisis:
Pinpointing particular nations within the 1994 Mexican emergency is troublesome. The capital
account venture came from a worldwide pool of financial specialists, not restricted to a single
country. However, major industrialized economies just as the Joined together States, Canada,
Japan, and Western European nations likely played noteworthy parts. These economies ordinarily
have huge venture stores looking for tall returns, and Mexico's appealing intrigue rates would
have been a major draw. Their consequent withdrawal of stores when certainty floundered would
have had a significant effect on the peso's debasement.
Other nations played a double-edged sword part in Mexico's 1994 emergency through capital
account speculation. Within a long time driving up to the emergency, other countries' speculators
were drawn to Mexico's financial changes and tall intrigued rates on short-term speculations.
This enormous influx of outside capital made a difference fuel Mexico's financial development
but also made a perilous circumstance. When political instability emerged (just like the death of
a candidate), and Mexico's capacity to reimburse its obligation got to be flawed, outside
speculators froze. They began pulling their cash out of Mexico en masse. This sudden capital
flight, where an expansive sum of outside ventures takes off rapidly, seriously debilitated the
Mexican peso's esteem and contributed altogether to the emergency. In substance, other
countries' ventures at first made a difference in Mexico's economy, but when things turned acrid,
their fast withdrawal of reserves played a major part in activating the monetary emergency.
Effect on the Economy during Crisis:
Recession: Mexico's economy dove into a profound retreat. Businesses battled, generation
contracted, and unemployment took off. This implied numerous Mexicans misplaced their
employment and confronted money-related hardship.
Inflation: The cheapening of the peso activated a surge in swelling. The costs of regular
merchandise skyrocketed, making it troublesome for individuals to manage necessities like
nourishment and lodging. This disintegrated obtaining control and advance crushed family funds.
Banking Crisis: The budgetary division was especially hard-hit. Numerous Mexican banks,
intensely dependent on short-term remote speculation, got to be wiped out as speculators pulled
out their cash. This caused a managing an account emergency, disturbing get credit and ruining
financial recuperation.
Poverty: The emergency essentially expanded destitution levels in Mexico. With work
misfortunes and rising costs, numerous Mexicans fell underneath the destitution line. The
financial hardship excessively affected the foremost defenseless parts of society.

Policies:
The developing economies are vulnerable to a “Mexico-style “financial crisis. These crises are
devastating, causing significant drops in GDP, consumption, and investment. Therefore,
policymakers need as a very important policy objective, to aim at avoiding such crises, as they
are extremely costly to the domestic economy. it is important to stress that Mexican GDP fell by
7% in 1995, consumption declined by over 17% and investment fell by 30%.

The following criteria for macro policy seem essential:

1. Current account deficit: An unstable current account deficit should be avoided

especially for a longer period that is difficult to establish in advance. limiting current
account deficits to sustainable levels of 3 to 4% of GDP for slow-going economies.
2. Favouring flexible exchange rate: A flexible exchange rate might cause inflation, but it
also reduces the risk of economic decline. It reduces the risk of business closing and job
losses. Fixed exchange rates can be tempting for the government to control inflation
quickly. However, a crisis can lead to a much sharper rise in inflation later. Ideally,
countries should discourage large inflows of short-term capital to avoid these difficulties.

3. Public debt management: Economic authorities should avoid short-term foreign

currency debt and consider tinge towards long-term debt even if long-term debt implies a
somewhat higher cost in interest payments.

4. Foreign exchange reserves: Maintaining high foreign exchange reserves to handle

capital flows volatility. Sharp declines in foreign exchange reserves require a PD policy
response, and should never be dismissed as a temporary problem.

The Asian Financial Crisis of 1997-1998

Started in Thailand, the Asian Financial Crisis erupting in the middle of 1997 to the end of 1998
spread drastically as the economies were interconnected and started a domino effect by first
affecting ASEAN-4 or ‘tigers’ (Thailand, Indonesia, Malaysia, and the Philippines), then
spreading to North Asia (South Korea, Taiwan, Hong Kong, and Japan), and finally shifting
outside the region and affecting industrial countries such as Brazil and Russia’s equity markets.
It shook the world as the crisis began and crushed the economies that were considered stable
with strong growth records. However, weak institutions, lack of supervision, and political
reasons along with other external factors triggered the vulnerabilities present in financial and
banking sectors with doubtful loans, heavy foreign borrowing, and risks - hidden by currency
pegs.

With liberalizing domestic financial markets, these countries allowed a huge inflow of capital
inflow, in the form of FDIs and portfolio investments. Between 1990 and 1998, the FDI flow
increased by 5 times, but the portfolio investment flows rose by 15 times (from $148 million in
1990 to $2701 million in 1998) of their initial value. The higher profit expectations and
indistinguishability led these countries to use these short-term loans in sectors that need long-
term investment leading deeper into the risk of crisis. When external factors such as USD
appreciation, the emergence of China as a competitor in the global market, and the Japanese
economic fall occurred, all these economies fell apart.

Fall of the First Card: Thailand

The initial stage of the Asian Financial Crisis or ‘TomYam Kung Crisis’ began with Thailand’s
decision to devaluate its currency, the Baht on 2 July 1997, abandoning its exchange rate peg
with the US dollar.
Background:
The early 1990s was the Thai economy’s golden period as it was the favorable choice of
investors from abroad and gained a massive amount of capital inflow due to accommodating
economic policies, healthy conditions, and some exogenous factors like stagflation in Japan and
recession in Europe.
The Thai government had a good reputation for maintaining long-run stability in the nominal
exchange rate as it was fixed to the US dollar, a low inflation rate (between 3.31% to 5.86%),
and a surplus in fiscal balance (table 1), along with all it had decided to start financial market
deregulation and capital account liberalization. This made many international speculators
channel huge amounts of capital out of Japan to Thailand. By 1995, the net capital inflow was
$14.239 billion, more than a 100% increase from its net capital inflow three years ago.
Table 1: Government Fiscal balances (% of GDP)

1992 1993 1994 1995 1996 1997

Korea -0.05 0.64 0.32 0.30 0.46 0.25
Indonesia -0.44 0.64 1.03 2.44 1.26 0
Malaysia -0.89 0.23 2.44 0.89 0.76 2.52
Philippines -1.16 -1.46 1.04 0.57 0.28 0.06
Thailand 2.9 2.13 1.89 2.94 0.94 -0.32
Source: World Bank
This huge overflow of capital expanded the banking sector rapidly (there were more than 50 new
banking and non-banking institutions) and between 1990-96 Thailand’s investment rate was
higher than its competitor countries in East Asia, along with 175% growth in the stock market
and 395% growth in the property sector.
Thai banks broke records in loan growth by
taking advantage of a large interest rate
difference (up to a 4-point percentage)
between foreign borrowing and local
lending, resulting in a lending boom of 58%,
the highest in East Asia.

Table 2: Lending Boom Measure (rate

of growth between 1990 and 1996 of the
ratios between the claim of the private
sector of the deposit money banks and
nominal GDP)
 Korea 11%
Indonesia 10%
Malaysia 31%
Thailand 58%
What went wrong?
The ‘golden period’ started to crumble in 1995 as Thailand’s economic growth slowed down.
It all started from the lending from abroad - as they were not planned properly, most of the
investment was done in non-productive and non-tradable sectors, resulting in lower exports and a
weak balance of trade. Inward FDI was also getting lower from 33.57% in 1990 to 15.90% in
1996.
Thai banks borrowed heavily in dollars but they lent domestically, in Baht. This currency
mismatch had a bigger risk as if any sudden repayment were to be done, this would weaken the
domestic currency and contribute to the crisis.
Foreign asset to liability data shows an increasing trend in Thailand from 6.93 in 1993 to 11.03
in 1996, whereas countries in the same region never exceeded 4.3 in the same period. Real estate
became unprofitable because of the ‘oversupply of vacant buildings’ which resulted in increasing
non-performing loans to 13% in 1996. The real estate crisis spilled to the banking system as ‘bad
loans’ started to deteriorate banks’ balance sheets. The exogenous factors - the emergence of
China as a competitor in international trade; decreased demand for major export goods,
semiconductors, and appreciation of dollars - all contributed to a balance of trade deficit.
Another factor was that Thailand had a persistent deficit in high amounts in the current account
in this period due to the trade deficit and long-run expected economic growth from the bubble of
the boom period - which further hurt the reserve making Thailand’s financial system more
fragile.

Table 3: Current Account, BOP Definition (% of GDP)

1990 1991 1992 1993 1994 1995 1996 1997

Korea -0.69 -2.83 -1.28 0.3 -1.02 -1.86 -4.75 -1.85
Indonesia -2.82 -3.65 -2.17 -1.33 -1.58 -3.18 -3.37 -2.24
Malaysia -2.03 -8.69 -3.74 -4.66 -6.24 -8.43 -4.89 -4.85
Philippines -6.08 -2.28 -1.89 -5.55 -4.6 -2.67 -4.77 -5.23
Thailand -8.5 -7.71 -5.66 -5.08 -5.6 -8.06 -8.1 -1.9
Source: World Bank
All these led the speculators to claim back their foreign assets leading to a credit crunch problem
(significant reduction in the availability of loans, and credits from banks). Thai banks and
financial institutions started to fall apart as they couldn’t repay the debt.
As an attempt to defend its currency, the government announced to buy $3.9 billion in bad
property debt, but failed miserably. The attempt to save ‘Finance One’, the largest finance
company in Thailand was also a failure. In the meanwhile, Thailand used up $28 billion out of
the $30 billion international reserve by June 1997.
Another major exogenous role was played by Japanese banks as they were the largest suppliers
of bank credit in Asia after their poor domestic financial environment, with $275 billion of loans
(54% in Thailand) accounting for one-third of cross-border lending.
To keep the exchange rate fixed with the dollar, the central bank started supplying dollars from
reserve to the economy and buying Bahts, trying to increase the demand for Bahts against the
Dollar as capital was flowing out of the country rapidly. Expecting a devaluation, speculators
started selling Bahts more against the dollar (the first massive speculative attack was in mid-
May, 1997), which acted as the last nail in the coffin. The government was forced to change its
exchange rate policy to a flexible exchange rate system on July 2, 1997, devaluating the currency
by 15-20%.

Failed Government Policies:

One of the main reasons for Thailand’s fall was the ineffective and impractical policies taken at
the wrong times. To further evaluate-
1. The capital account liberalization was not a timely decision as it was the core reason for
the huge foreign liability ratio, non-performing loans & lower inward FDI. Most of
Thailand’s high GDP growth in the 1990s came from the production of non-tradable
goods, thus getting a huge amount of capital without institutional reforms to use it
effectively was reckless.
2. Political influence played a huge role as even with Mexico’s case study, the government
didn’t warn people to limit their excess expenses leading to a trade deficit as they wanted
to maintain the prosperous image. Even after the crisis, delaying the IMF rescue package
for 26 days also added to the further downfall of the currency and economy.
3. Right after the first devaluation, the Thai government took a loose monetary policy (low
interest rate, increased money supply) which failed as bank panic spread and people
withdrew money instead of investing. This resulted in continued currency devaluation.
Then Thai government changed to a tight monetary policy to raise interest as a way of
keeping money in the system. Again, it backfired as borrowing became expensive and the
credit crunch began, hindering economic growth.

Recovery Period:
During the crisis, the Thai government was forced to negotiate loans as they accepted the IMF
package, closed 58 banks and financial institutions, and reformed state-owned enterprises.
From November 1997 to December 2000, the Government focused on post-crisis measures, such
as
 Increased interest rate to control inflation and attract capital inflow (to appreciate Baht
against the dollar)
 Restored financial institutions that were closed down and sold shares to foreigners to
raise funding capital for state-owned banks
 Took out a loan of 53,000 million in Baht from Japan, lowered import tax for goods used
as raw materials of export goods, restructured public sector debt to reduce NPL, and
increased capital for SMEs
To prevent a future crisis similar to the 1997 Financial crisis, the government took many
initiatives such as the Chian Mai Initiative (a self-help support system with neighboring nations),
AMRO, ABMI, etc.
Starting the Domino Effect:
After the fall of Thailand, investors began to shrink their capital from regional countries as they
expected a future devaluation and their confidence broke. Even though the other countries had
slightly different economic models despite all of them being export-oriented economies, the
investor panic spread, and the contagion started. The neighboring countries suffered from
currency attacks, high debt, and sinking exchange rates as the devaluation of Thai Baht ignited
concerns over their economic outlook and exchange rate arrangement. Of them, Indonesia, South
Korea, and Malaysia had it worst in that region as they had weak institutions.
The value of the Indonesian Rupiah fell by 80%, the South Korean Won by nearly 50% and the
Malaysian Ringgit by 45%.
Table 4: Exchange Rate in terms of Dollar

Year 1990 1991 1992 1993 1994 1995 1996 1997 1998
Korea 707.76 733.35 780.65 802.67 803.45 771.27 804.45 951.29 169.5
Indonesia 1842.8 1950.3 2029.9 2087.1 2160.8 2248.6 2342.3 2909.4 4650
Malaysia 2.7 2.75 2.55 2.57 2.62 2.5 2.52 2.81 3.89
Thailand 25.59 25.52 25.4 25.32 25.15 24.91 25.34 31.36 47.25
Singapore 1.81 1.73 1.63 1.62 1.53 1.42 1.41 1.48 1.68
Source: World Bank

Indonesia:
The economic golden period for Indonesia started with its second president Suharto and his
‘New Order Development’ in the mid-1960s changing the country’s economic fate.
Background:
The main focus of the ‘Economic Recovery’ period from 1966 to 1973 was to reintegrate into the
world economy which started the flow of foreign aid and financial assistance from Japan and the
West. Along with it, new policies were implemented successfully to curb hyperinflation by
banning domestic financing by money creation or debt, and to ignite rapid economic growth,
handsome incentives were set for investors.
In the second stage of the New Plan from 1974 to 1982, the two oil booms acted as exogenous
factors in increasing Indonesia’s export earnings and government revenue. This enabled the
government to prioritize public spending, investing in infrastructure, and establishing import-
substitute industries. As government earnings had increased, Indonesia was free from depending
on foreign capital investment and rather it supported the indigenous business.
The third phase of the New Plan lasted from 1983 to 1996 and the trajectory of government
policies turned again as oil prices started to fall in the early 1980s. As oil has been the main
source of government earnings in the last decade, to compensate for this and maintain
macroeconomic stability now the government had to take more investment-friendly policies and
tight monetary policies -
  Devaluation of domestic currency (Rupiah) in 1983 to control the rising current account
deficit
 Introduction of new tax law to increase non-oil taxes and government earnings
 Deregulation of banks to allow them to set interest rates freely to encourage economic
activities and create an investment climate for the private sector
 Exception of import duties to encourage more exports
 Allowing to establish new private banks
All these led Indonesia’s GDP to grow by 9% on average each year from 1988 to 1991 and the
GDP growth slowed down to 7.3% from 1991 to 1994 and later increased again. These
measurements also increased foreign investment in Indonesia, specifically in export-oriented
industries.

The Beginning of the Crisis:

Unlike Thailand, Indonesia had a managed exchange rate regime and the stable currency along
with other factors increased capital inflow in the early and mid-1990s which appreciated its
REER(real effective exchange rate) in 1996 ( from 100 to 105). However, due to new
competitors in the global market (China, Vietnam, India) and oversupply of the export
commodity, export growth declined slightly and the deficit in the current account continued. The
deficit was financed by high-level short-term debts as raised interest rates and unwillingness to
depend on FDI, attracted short-term capital inflow.

Table 5: External Debt Indicators, 1990-1997

Country FDI Inflation as a Public Short-term Foreign Debts as a

Share of GDP Share of GDP

Average Average 1996 1997

1990- 1996 1990-1998
1995

1.4 2.8 11.5 14.2 16.7

Indonesia

1.7 1.5 16.5 20.7 23.2

Thailand

7.3 8.0 6.9 11.0 14.9

Malaysia

1.6 1.8 9.3 96 14.4

Philippine

Source: World Bank

These unstable macroeconomic factors laid out the pathway for the crisis that was about to
happen in Indonesia.
There were little to no trade links between Thailand and Indonesia, but they both had a common
creditor -Japan, which explains the “Contagion Effect”. Japan had a share of 35% of the total
foreign debt in Indonesia. Thus, when Japanese banks opted out, Indonesia fell into deep trouble.
Another factor was asymmetric information, which led investors to lose expectation and
confidence in the Indonesian market as they assumed it had the same condition as Thailand.
All these influenced investors to withdraw a massive amount of capital - $9.6 billion in 1997 and
$7.8 in 1988, depreciation of the Rupiah reached over 70%, the fall in stock exchange index
reached 50% - and the economy fell apart.
The main actors behind the crisis were -
 Structural rigidities from trade restrictions, import monopolies, and regulations created a
lack of transparency and an environment for corruption
 Twin liberalization of the banking system and capital account led to high interest rates
and huge short-term portfolio and equity investment or private sector debt accounting for
$74 billion
 Deregulation of banks and poor central bank governance led to the blindness towards
crisis

Recovery:
The IMF rescue package of $43 billion over a 3-year-period was received on 31st October 1997
along with conditions for macroeconomic stability and structural reforms.
Indonesia stomped on the gas (interest rates) to save its crashing currency, hurting businesses.
Now recovering, they're ready to ease off the gas, but stay alert for more trouble. The crisis
crushed Indonesia's budget plan. Spending soared, taxes plunged, and social needs exploded.
Deficits ballooned to 4%, needing more foreign aid to stay afloat.
Indonesia backed the crisis by -
opening trade, selling state businesses (slow due to market) to get money and improve efficiency,
closing many weak banks and merging strong ones to fix the banking sectors, and guaranteeing
deposits. They also let foreigners own banks and made new rules to prevent future problems.

South Korea:
Background:
The Republic of Korea was an ‘economic miracle’ with an average growth rate of over 9% for
30 years. After independence, the broken, corruption-collapsed country changed its course of
economic growth with some reforms such as establishing ‘Chaebol” (Korean Conglomerate) ,
devaluating currency to promote export, and re-nationalizing banks to guarantee private sector
foreign borrowing. With a new hybrid economic model containing a healthy mix of free market
and state intervention, Korea was able to increase exports, invest in human capital, increase
industrialization, and solve its structural problem. All these attracted foreign investors, and by
1969, the state took over 30 firms and IMF intervention started due to uncontrollable borrowing
and unable to pay back. After the crisis of 1972 set in, the government partnered with Chaebols
to establish Heavy Chemical Industries (HCI) which further increased foreign borrowing and
economic growth.
South Korea focused on some reforms in the 1980s - reprivatizing banks; giving easier access to
loans to SMEs; focusing on heavy industries over agriculture, fishing, and mining; urging
Chaebols to focus on specific regions; democratization, high trade barriers, etc. The reforms
were on the right path, but the high influence of Chaebols and low competitiveness limiting long-
term economic growth remained in the economy.

Factors that Spread the Crisis:

In the early 1990s, Korea achieved a stable economy with a 7 to 9% average growth rate,
controlled inflation, and foreign debt to GDP ratio of less than 30%, the lowest in the region. The
only drawback was the current account deficit.
In that period, manufacturing labor was getting expensive, the export sector started to decline
and firms started earning lower profits. They started to supply non-tradable goods with high
profit and low technology in domestic-oriented markets, shifting firms from export-oriented
tradable goods and markets. The importance of manufacturing sectors declined while service
sectors expanded continuously. Along with it, China’s emergence as a semiconductor exporter in
the global market severely impacted the export growth of Korea.
The Korean financial sector had 4 types of banks that lacked unified supervision and
coordination allowing risky practices among private institutions.
Such as the deregulation of commercial banks led to banks offering long-term loans domestically
with short-term borrowed capital from foreign investors (as the short-term foreign borrowing rate
was lower).
As the Korean Won was pegged to the American Dollar, an appreciation in USD resulted in a
further trade deficit. But as the Japanese Yen depreciated against Won, it drained loans out of
Korea, resulting in a credit crunch. All these internal and external factors along with weak
institutions forced Korea to use its foreign reserve to back the short-term loans, quickly lowering
its usable reserve to a risky level. Real GDP growth rate fell to a negative 5.8% in 1998. With the
collapse of the stock market and loss of confidence, investor panic spread, and eventually on
November 21, 1997, the Korean Government announced assistance from the IMF.

Recovery:
As per IMF instruction, the South Korean government took initiatives to tighten monetary policy
and the exchange rate was set to a flexible regime to tackle the crisis. Minimum interference in
the free market, the main fiscal policy focus was reducing current expenditure and widening
corporate tax, VATs, and income tax to maintain a minimum budget balance.
Along with these, restructuring and reform in financial institutions, transparency, trade, and
capital account liberalization to initiate capital inflow into the economy, labor market reform,
and information availability were also implemented.

Malaysia:
Despite being on the list of countries affected by the Asian Financial Crisis of 1997, Malaysia
was the only country that didn’t need an IMF relief package as they had a stronger
macroeconomic buildup than other severely affected countries discussed earlier. After being a
victim of the severe banking crisis in the 1980s, the regulatory measures taken then saved
Malaysia from bankruptcy in the 1977 crisis.
Background:
Malaysia had a sound and stable economy before the crisis with healthy macroeconomic
indicators such as a high growth rate, full employment, and low inflation rates for over 10 years.
The economic growth rate between 1990 to 1997 was around an average of 8.7% with low
unemployment and inflation. Between 1995 and 1997, domestic savings were a share of almost
40%, and Investment share was around 45% of the GNP. The external debt was around 50% of
the GNP, and the external debt ratio was below 6.9% of exports.
Even though it constantly had a deficit in the current account, it was a smaller share and could
easily be backed up by foreign reserves. Overall, the environment was healthy enough to attract
many foreign investments, both short-term portfolio investments and long-term FDIs.
The Crisis:
However, some emerging concerns were setting the crisis environment, such as
Actual GDP was exceeding potential GDP, which further created price pressure and increased
wages above labor productivity as most of the inputs were imported. The Total Factor
Productivity declined in 1996-97 as the economy was shifting towards high technology and
knowledge-based industries which initially needed more capital - which pointed towards
inefficient use of capital.
Along with this, Malaysia’s investment rate exceeded its savings, despite having the highest
savings in the region, which caused the current account deficit. The total loan growth faced a
steeper upward trend from 1995, creating excessive credit expansion in non-tradable industries.
As the Thai Baht collapsed in mid-1997, currency speculators started to attack other similar
currencies pegged to the dollar unsustainably, and panic among the investors spread quickly. The
Ringgit became weaker against USD by 37% and the stock market declined by 68.58%.
Capital outflow increased abruptly and stood over 11%.
The economy collapsed with a negative GDP growth rate, the real economy contracted by 14%,
huge unemployment, instability, firm bankruptcy, massive foreign debt, and banking crisis, etc.
Recovery:
Despite the economy falling apart, the Government decided to decline IMF assistance, and
centralized all economic decisions by creating a National Economic Action Crisis with the focus
on -
 1. Restructuring the banking sector
2. Stabilizing Ringgit
3. Reassuring Market reliability
4. Maintaining financial market stability
They decided to reduce the interest rate from 11% to 3% gradually, banned offshore trading of
Ringgit and shifted to a fixed exchange regime for stabilizing currency to support affected export
industries, expanded fiscal policy - created a debt restructuring agency (Danaharta) to back the
non-performing loans and reassured banks.
These policies were highly criticized by the IMF but brought fruitful results in a shorter period
than other affected countries following IMF assistance. The current account balance recovered
from a deficit of RM17 billion in 1997 to a surplus of RM 37 billion in 1998. Even though Real
GDP fell by 7.4% in 1998, it grew by 6.1% in 1999 with a declining unemployment rate (less
than 3%) and expanded manufacturing industries (by 13.5%).

The Reasons Behind the Crisis:

1. Moral Hazard: In an early analysis, Jeffery Sachs described the reason as a problem of
moral hazard that occurred from adverse selection.
The institutional setting in East Asia in the 1990s incentivized undercapitalized banks and
unregulated finance companies to leverage their balance sheets while taking on both
exchange rate and maturity-mismatch risks. The government was actively involved in
lending to politically connected businesses [such as in Korea, banks were directed to give
huge amounts of loans to Chaebols, industries, and small & medium enterprises(SMEs).
In Thailand, government policies provided tax incentives for foreign borrowing]. The
banks and financial institutions (near banks) acted as mediators or channeling bodies of
this capital inflow. Thus, banks were freely lending money as they had little to no risk &
for any risk, the government would give bailouts and protect the creditors. The creditors
were also confident in the government's safety net and borrowed without evaluating bank
health.

2. Role of Japanese Banks:

Even after having almost the same financial situation and pegged exchange rate, the crisis
began in Thailand and not in South Korea because Japanese banks held over 50% of
foreign bank loans in Thailand, but only 25% of loans in South Korea, according to King.
Table 6: Change in Japanese bank loans (in US $ billions)

end-94 to end- end-96 to mid-97 to end-97 to mid-97 to mid-

96 mid-97 end-97 mid-98 98
Thailand 11.11 0.2 - 4.6 - 7.1 - 11.6
 South 6.9 - 0.6 - 3.5 - 4.8 - 8.3
Korea
Source: BIS
After the stock market collapse and the real estate bubble in the 1980s, Japan’s domestic
environment deteriorated quickly, forcing Japanese banks to look for profitable
investments abroad. They were the largest creditors in Asia, with $275 billion of loans,
accounting for one-third of cross-border lending, making them key marginal lenders with
significant power over these markets. When the stock market started to crumble in Asia
in 1995, the US stock market began to return with 35% growth, shifting many investors
from Asia to the USA. With the deteriorating domestic situation and falling trend in
Asian stocks, Japanese banks retreated and stopped issuing new loans abroad. The
Japanese out-flow accounted for $12 billion in Thailand, $8 billion in South Korea, and
$4 billion in Indonesia from mid-1997 to mid-1998.

3. Pegged Exchange Rates:

To achieve currency stability and attract foreign investment, several East Asian nations
adopted pegged exchange rates. Despite its initial advantages in terms of inflation control
and export stimulation, this policy ultimately resulted in currencies becoming overvalued.
The sustainability of maintaining these fixed rates diminished as economic conditions
declined, resulting in significant devaluations, a decline in investor trust, and a rise in
economic instability.

4. Weak Economic Fundamentals:

(a) High Short-Term Debt:
East Asian nations gained significant levels of short-term foreign debt, which contributed to the
development of economic vulnerability. Their dependence on short-term financing rendered
them at risk for sudden changes in market sentiment and capital flight, which in turn led to
liquidity crises triggered by a decline in investor confidence.

Table 7: Short-term External Debt as a percentage of Foreign Exchange Reserves

Indonesia Korea Malaysia Thailand Philippines

End-1993 171 148 28 89 52
Mid-1997 182 214 62 153 88
th
Source: Bank for International Settlement – 68 Annual Report

(b) Overheated Asset Markets and Weak Financial Systems:

The rapid growth caused by speculative investments in the real estate and stock markets led to
asset bubbles. Moreover, financial systems that were weak and poorly regulated indulged in
risky lending activities without sufficient supervision. The aftermath of financial losses and
instability that occurred as a result of the bursting of asset bubbles further aggravated the
economic crisis.

Case Study: Comparative Analysis of the Mexican Peso Crisis and the Asian Financial
Crisis
Prelude to the Crisis:
There was a lot of net capital inflow in Mexico and Asian because of structural changes,
macroeconomic stabilization and exceptional economic development. Due to slow growth and
low interest rates in industrialized countries, investors looking for better returns put a lot of
money into emerging markets, possibly without fully understanding the risks involved. This
trend mostly benefitted Mexico and Asian countries.

Chart 1: Capital flow increased precrisis (IMF)

Shared Vulnerabilities
Both Mexico and the Asian economies (Indonesia, Korea, Malaysia, the Philippines, and
Thailand) exhibited several common vulnerabilities that predisposed them to financial crises.
Understanding these shared weaknesses offers valuable lessons for future economic policy and
financial regulation.
1. Consequences of Capital Inflows:
The consequences of capital inflows were significant in both Mexico and the Asian economies,
as they worsened vulnerabilities. The initial appeal of fixed exchange rates was the stability it
offered, which encouraged foreign investment. However, this stability also resulted in the
expansion of external current account deficits, particularly in Mexico. The influx of money into
Mexico from 1990 to 1994, amounting to $104 billion, led to an increase in its external current
account deficit. The growth in capital, together with other factors like fast credit expansion and
maintaining a fixed currency rate, made Mexico more susceptible to external shocks. In a similar
manner, massive capital inflows, which included short-term speculative flows, contributed to the
formation of asset bubbles and increased vulnerabilities in the financial systems of different
Asian countries.
 2. Dependence on Fixed Exchange Rates:
Both regions maintained pegged exchange rates, often tied to
the US dollar, which initially provided stability and attracted
foreign capital. However, these fixed exchange rates became
liabilities as they led to currency overvaluation and eroded
competitiveness. Over time, this misalignment contributed to
trade imbalances and economic strain. This hurt domestic
industries and widened trade deficits, further weakening
economic fundamentals.
Table 8

3. Speculative Attacks:
Both crises were caused by currency speculation. Mexico's concerns
about exchange arrangements and weak financial systems led to a
speculative attack on the peso. In Asia, the depreciation of the Thai baht
led to a wave of speculative attacks that made the financial problems
even worse. Due to the weakness of domestic financial systems, it was
impossible to defend currency parities indefinitely by drawing down
reserves and raising interest rates. This led to drastic devaluations. In
addition, the stock markets in Asia and Mexico both declined.
Table 9

4. Weakness of Financial Systems:

 Mexico's banking system was weakened by liberalization and privatization, resulting in
rapid credit expansion without proper supervision and regulation. The 1982
nationalization of banks led to a loss of experienced personnel and subsequent lending
practices were not rigorously assessed for credit and market risks.
 In Asia, banks were closely connected with industrial groups and the government,
functioning more as instruments for industrial promotion than as financial intermediaries.
Poor regulation, lax controls, and risky lending practices exposed the company to
exchange rate risks from foreign capital.

Key Differences
Despite these shared vulnerabilities, the Mexican Peso Crisis and the Asian Financial Crisis had
distinct triggers, dynamics, and recovery paths, shaped by their unique economic contexts and
policy responses.
1. Triggers of the Crisis:
 Mexico (1994): Political instability, including the assassination of a presidential
candidate, led to capital flight by Mexican residents. The capital outflow and high current
account deficit caused immense pressure on the peso, leading to a sharp devaluation.
 Asia (1997-98): The Asian crisis started with the devaluation of the Thai baht, raising
concerns about fixed exchange rates in the region. Lax lending and short-term borrowing
made these economies susceptible to contagion, causing investor panic and capital flight.

2. Duration and Severity:

Chart 2: Deviation of Actual Output from Precrisis Trend

 During Mexico's recession, the country's GDP fell by approximately 15% compared to
the trend that existed prior to the crisis. The economy recovered swiftly, narrowing the
gap to 5% within 10 quarters of the crisis.
 Asian countries saw greater deviations from pre-crisis growth rates. There were
discrepancies ranging from 25-30 percent in Malaysia, Thailand, and Indonesia. Despite a
steep V-shaped rebound, these countries closed the output gap slower than Mexico.

3. Investors' Expectations:
 Local investors initially had confidence in the economy, but policy inconsistencies and an
unsound banking system led to a loss of confidence and capital flight by Mexican
residents.
 The Asian crisis was primarily triggered by foreign investors. These investors, seeking
high returns, moved vast amounts of capital into the region. However, when the
underlying weaknesses became apparent, these investors abruptly withdrew their funds,
leading to massive capital outflows.
Economic Impact and Recovery Patterns
 Net Exports
Net exports played a crucial role in cushioning the economic contraction during the crises.
 Chart 3: Contribution of Net Exports to GDP growth (Hongkok Monetary Authority)
 Mexico experienced a steady export recovery, contributing positively to GDP growth.
 Asian countries faced more unstable export rebounds, with initial recovery being
disrupted by financial and social instability. Import contraction played a more significant
role in improving external balances in Asia compared to Mexico.

 Investment
Investment was a critical factor differentiating the recovery paths.

Chart 4: Contribution of Investment of GDP growth (Hongkong Monetary Authority)

 In Mexico, investment rebounded, contributing to GDP growth.
 The investment collapse was more severe in Asia, accounting for 30-50% of GDP
precrisis, compared to less than 20% in Mexico. Investment levels in Asia remained
below precrisis levels for a longer period.

 Stock Market Performance:

 Improved investor sentiment in Mexico was reflected in their stock market performance.
The Bolsa Mexicana de Valores Index bottomed out two months after the Mexican peso
float.
 In contrast, Asian economies did not show a strong upward trend until 14 months after
their depreciations. Investment in Southeast Asian nations had a greater reduction than
 Mexico and South Korea during the initial crisis period, contributing less to GDP growth.

 Consumption

Chart 5: Contribution of Consumption to GDP growth (Hongkong Monetary Authority)

 Consumption, accounting for about 2/3 of aggregate demand, exhibited sharp
contractions during the crises.
 Recovery Time: It took about 46 quarters for consumption to recover and contribute
positively to GDP growth in both Mexico and Asia, indicating similar patterns in the
consumption recovery process.

 Policy Responses:
 The Mexican government implemented decisive fiscal and monetary policies, supported
by substantial international financial aid. This prompt policy response helped stabilize the
currency and reignite economic activity.
 The policy responses in the Asian economies were less forceful and supported by smaller
financial aid packages. This, combined with the complexity of dealing with multiple
affected countries, contributed to a more protracted and uneven recovery.

Conclusion:
The Tequila Crisis in Mexico and the Asian Financial Crisis are significant turning points in the
history of international finance. These events revealed weaknesses, eroded trust, and reshaped
economic models. In conclusion, these crises highlight the importance of maintaining adaptable
exchange rate policies, assuring responsible financial management, and promoting stable
economic institutions. The lessons learned from these economic downturns remain significant in
shaping current economic strategies, highlighting the significance of vigilance, flexibility, and
global cooperation in reducing future financial instability. Given the interconnected and complex
nature of global financial markets, these past events offer useful insights for constructing
economic systems that are more resilient and stable.
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