# Understanding the Asian Financial Crisis: Causes, Effects, and Lessons

![Asian Financial Crisis: A major financial crisis triggered by a sequence of currency devaluations that destabilized the Asian economy in 1997 and 1998.](https://www.investopedia.com/thmb/qJ-pvcVLQ8X8MwLldqSULndO4fM=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Asian-financial-crisis_final-3418f3abac8b42cc9d8802181f1a57a5.png)

*The countries most affected by the crisis were Indonesia, South Korea, and Thailand. — Michela Buttignol / Investopedia*

> **Definition**
>
> The Asian financial crisis was spurred by the collapse of the currency exchange and affected Asian economies from 1997 to 1998.

## What Was the Asian Financial Crisis?

The Asian financial crisis, known as the "Asian [Contagion](https://www.investopedia.com/terms/c/contagion.asp)," started in July 1997 with [currency devaluations](https://www.investopedia.com/terms/d/devaluation.asp) spreading across Asia.

The crisis began in Thailand when the government stopped the local currency's peg to the U.S. dollar after using up [foreign exchange reserves](https://www.investopedia.com/terms/f/foreign-exchange-reserves.asp) to fend off speculative pressure.

### Key Takeaways

*   The Asian financial crisis of 1997 began in Thailand and quickly spread across Asia, resulting in currency devaluations, economic contractions, and recessions in multiple countries.  
    
*   The International Monetary Fund intervened with substantial bailouts for several Asian countries, but these came with strict conditions for economic reforms and spending cuts.  
    
*   Key causes of the crisis included over-leveraged economies, excessive unregulated borrowing, and risky investment practices fueled by government policies that promoted rapid growth.  
    
*   The crisis highlighted the dangers of asset bubbles, moral hazards in market investments, and the impact of interconnected global markets, serving as a case study for economists worldwide.  
    
*   Lessons from the crisis emphasize the importance of regulatory oversight, prudent economic policies, and awareness of macroeconomic vulnerabilities to prevent future financial disasters.

Weeks after Thailand ceased defending [its currency](https://www.investopedia.com/terms/forex/t/thb-thai-baht.asp), Malaysia, the Philippines, and Indonesia had to let their currencies fall due to market pressure. By October, the crisis spread to South Korea, where a [balance-of-payments](https://www.investopedia.com/terms/b/bop.asp) crisis brought the government to the brink of [default](https://www.investopedia.com/terms/d/default2.asp).

Other [economies](https://www.investopedia.com/terms/e/economy.asp) also came under pressure, but those with solid economic fundamentals and hefty foreign exchange reserves fared much better. Hong Kong fended off several major but unsuccessful speculative attacks on [its currency](https://www.investopedia.com/terms/forex/h/hkd-hong-kong-dollars.asp), which is pegged to the [U.S. dollar](https://www.investopedia.com/terms/forex/u/usd-united-states-dollar.asp) via a currency board system and backed by massive U.S. dollar reserves.   

## Consequences of the 1997 Asian Financial Crisis

As the Thai baht fell, other Asian currencies fell—some precipitously. Across Asia, inflows of [capital](https://www.investopedia.com/terms/c/capital.asp) slowed or reversed.

The Thai baht had been trading at about 26 to the U.S. dollar before the crisis but lost half its value by the end of 1997, falling to 53 to the dollar by January 1998. The [South Korean won](https://www.investopedia.com/terms/forex/k/krw-korean-won.asp) fell from about 900 to the dollar to 1,695 by the end of 1997. The [Indonesian rupiah](https://www.investopedia.com/terms/forex/i/idr-indonesian-rupiah.asp), which had been trading at around 2,400 to the dollar in June 1997, plummeted to 14,900 by June 1998, less than one-sixth its precrisis level.

Some of the more heavily affected countries fell into severe [recession](https://www.investopedia.com/terms/r/recession.asp). Indonesia’s [gross domestic product (GDP)](https://www.investopedia.com/terms/g/gdp.asp) growth fell from 4.7% in 1997 to -13.1% in 1998. In the Philippines, it slid from 5.2% to -0.5% over the same period. Malaysia’s GDP growth similarly slid from 7.3% in 1997 to -7.4% in 1998, while South Korea’s contracted from 6.3% to -4.9%.

In Indonesia, the ensuing economic crisis led to the collapse of the three-decade-old dictatorship of President Suharto.

The crisis was alleviated by intervention from the [International Monetary Fund (IMF)](https://www.investopedia.com/terms/i/imf.asp) and [The World Bank](https://www.investopedia.com/terms/w/worldbank.asp), among others, which poured some $118 billion into Thailand, Indonesia, and South Korea to bail out their economies.  

![Asian Financial Crisis Hammers GDP](https://www.investopedia.com/thmb/xtTfWFHlEjSLVsaD6QtAwSq92ak=/664x0/filters:no_upscale():max_bytes(150000):strip_icc()/GDPchartfromIMFdataPNG2-de0459e707864230b17ed69d1ed86d2b.png)

**

As a result of the crisis, affected countries restructured their economies, generally because the IMF required reform as a condition of help. The specific policy changes were different in each country but generally involved strengthening weak financial systems, lowering [debt](https://www.investopedia.com/terms/d/debt.asp) levels, raising [interest rates](https://www.investopedia.com/terms/i/interestrate.asp) to stabilize currencies, and cutting government spending.

The crisis also serves as a valuable case study for [economists](https://www.investopedia.com/terms/e/economist.asp) to understand how interwoven markets affect one another, especially as it relates to currency trading and national accounts management.  

## Root Causes of the Asian Financial Crisis Explained

The crisis stemmed from various government policies and investment trends in the industrial, financial, and monetary sectors. Once the crisis began, markets reacted strongly, and one currency after another came under pressure. Some of the [macroeconomic](https://www.investopedia.com/terms/m/macroeconomics.asp) problems included [current account deficits](https://www.investopedia.com/terms/c/currentaccountdeficit.asp), high levels of [foreign debt](https://www.investopedia.com/terms/f/foreign-debt.asp), climbing [budget deficits](https://www.investopedia.com/terms/b/budget-deficit.asp), excessive [bank](https://www.investopedia.com/terms/b/bank.asp) lending, poor [debt-service](https://www.investopedia.com/terms/d/dscr.asp) ratios, and imbalanced [capital inflows](https://www.investopedia.com/terms/c/capital-flows.asp) and [outflows](https://www.investopedia.com/terms/c/capital-outflow.asp).

These issues often resulted from policies promoting [export-led economic growth](https://www.investopedia.com/articles/investing/011416/exportled-growth-strategies-through-history.asp) before the crisis. Governments worked closely with manufacturers to support exports, including providing [subsidies](https://www.investopedia.com/ask/answers/060215/how-do-government-subsidies-help-industry.asp) to favored businesses, more favorable financing, and a currency peg to the U.S. dollar to ensure an [exchange rate](https://www.investopedia.com/terms/e/exchangerate.asp) favorable to exporters.

While this did support exports, it also created [risk](https://www.investopedia.com/terms/r/risk.asp). Explicit and implicit government guarantees to [bail out](https://www.investopedia.com/terms/b/bailout.asp) domestic industries and banks meant investors often did not assess the profitability of an investment but instead looked to its political support. Investment policies fostered close ties among conglomerates, financial institutions, and their regulators.

Large volumes of foreign money flowed in, often with little attention to potential risks. These factors all contributed to a massive [moral hazard](https://www.investopedia.com/terms/m/moralhazard.asp) in Asian economies, encouraging major investment in marginal and potentially unsound projects. As the crisis spread, it revealed that the impressive economic growth rates were hiding serious vulnerabilities.

In particular, domestic [credit](https://www.investopedia.com/terms/c/credit.asp) had expanded rapidly for years, often poorly supervised, creating significant [leverage](https://www.investopedia.com/terms/l/leverage.asp) along with loans extended to dubious projects. Rapidly rising [real estate](https://www.investopedia.com/terms/r/realestate.asp) values (often fueled by easy access to credit) contributed to the problem, along with rising current account deficits and a buildup in external debt. Heavy foreign borrowing, often at short [maturities](https://www.investopedia.com/terms/m/maturity.asp), also exposed corporations and banks to significant [exchange rate](https://www.investopedia.com/articles/forex/082515/how-avoid-exchange-rate-risk.asp) and [funding risks](https://www.investopedia.com/terms/l/liquidityrisk.asp)—risks that had been masked by long-standing currency pegs. When the pegs fell apart, companies that owed money in foreign currencies suddenly owed a lot more in local currency terms, forcing many into [insolvency](https://www.investopedia.com/terms/i/insolvency.asp).

Many Asian economies entered [current account](https://www.investopedia.com/terms/c/currentaccount.asp) deficits. If a country has a current account surplus, that means it is essentially a net [lender](https://www.investopedia.com/terms/l/lender.asp) to the rest of the world. If the current account balance is negative, then the country is a [net borrower](https://www.investopedia.com/terms/n/net-borrower.asp) from the rest of the world. Current account deficits had grown on the back of heavy government spending (much of it directed to supporting continued export growth).

## How Governments and Institutions Responded to the Asian Financial Crisis

The IMF provided [loans](https://www.investopedia.com/terms/l/loan.asp) to stabilize the economies affected by the crisis. The IMF and others lent roughly $118 billion in short-term loans to Thailand, Indonesia, and South Korea. The bailouts came with conditions, though: Governments had to raise taxes, cut spending, and eliminate many subsidies. By 1999, many of the affected countries began to show signs of [recovery](https://www.investopedia.com/terms/e/economic-recovery.asp).

Other financial institutions also intervened. For example, in December 1997, the U.S. [Federal Reserve Bank](https://www.investopedia.com/terms/f/federalreservesystem.asp) brokered a deal under which U.S. banks owed money by South Korean companies on short-[term loans](https://www.investopedia.com/terms/t/termloan.asp) voluntarily agreed to roll them over into medium-term loans.

## Key Lessons Learned from the Asian Financial Crisis

Many of the lessons of the Asian financial crisis remain relevant today. First, beware of asset [bubbles](https://www.investopedia.com/terms/b/bubble.asp), as they have a habit of bursting. Another is that governments need to control spending and pursue prudent economic development policies.

## How Do Government Spending and Monetary Policy Affect a Currency’s Value?

When governments spend, implement policies that keep taxes low, subsidize the price of staple [goods](https://www.investopedia.com/terms/c/consumer-goods.asp), or use other methods that effectively put more money in people’s pockets, consumers have more money to spend. As most economies rely at least partly on [imports](https://www.investopedia.com/terms/i/import.asp) for many goods and [services](https://www.investopedia.com/terms/s/service-sector.asp), this increased spending creates demand for foreign currency (usually U.S. dollars), as importers have to sell local currency and buy foreign currency to pay for imports.

Demand for foreign currency (and selling of local currency to buy it) increases exponentially when those policies also promote heavy investment in infrastructure, new businesses, and other economic projects. As more local currency is offered for sale on foreign exchange markets, its value goes down, unless there is a corresponding demand to buy it (say, by exporters selling foreign currency that they earn from [exports](https://www.investopedia.com/terms/e/export.asp)).

## Why Do Governments Keep Exchange Rates High?

Governments, especially in [developing economies](https://www.investopedia.com/terms/e/emergingmarketeconomy.asp), seek to manage exchange rates to balance their ability to pay debts denominated in foreign currencies. Because investors generally prefer instruments denominated in more stable currencies, governments in developing economies often raise funds by issuing bonds denominated in U.S. dollars, [Japanese yen](https://www.investopedia.com/terms/forex/j/jpy-japanese-yen.asp), or [euros](https://www.investopedia.com/terms/e/euro.asp).

However, if the value of the domestic currency falls vs. the currency in which its debt is denominated, that effectively increases the debt, as more local currency is needed to pay it. So, when the Thai baht lost half of its value in 1997, that meant local borrowers needed twice as many baht to pay debts denominated in U.S. dollars. As many developing countries also rely on imports, a higher-valued local currency also makes those imports cheaper in local currency terms.

## Why Do Governments Keep Exchange Rates Low?

Conversely, governments may seek to keep their exchange rates low to increase the competitiveness of exports.

In the 1980s, following years of complaints from U.S. companies about competition from cheap Japanese imports, the U.S. government convinced Japan to allow its currency to [appreciate](https://www.investopedia.com/terms/a/appreciation.asp) as part of the [Plaza Accord](https://www.investopedia.com/terms/p/plaza-accord.asp). The currency’s value climbed from 250 yen to one U.S. dollar in early 1985 to less than 130 yen by 1990. The U.S. [trade deficit](https://www.investopedia.com/terms/t/trade_deficit.asp) with Japan fell from $55 billion in 1986 to $41 billion in 1990.

## Summarizing the Asian Financial Crisis: Key Takeaways

In 1997, decades of economic policy planning that featured close relationships among government policy planners, regulators, the industries they regulated, and financial institutions came to a head when markets began putting downward pressure on Asian currencies. The most vulnerable were those countries with high levels of debt and insufficient financing to pay it.

The IMF stepped in to bail out the most affected economies, but it imposed strict conditions in exchange for the help. Some measures included requiring governments to cut spending, raise taxes, eliminate subsidies, and restructure their financial systems.

The crisis serves as a case study in asset bubbles and how rapidly [panic selling](https://www.investopedia.com/terms/p/panicselling.asp) can cause uncontrollable contagion.

> **Article Sources**
>
> 1.  Federal Reserve History. “[Asian Financial Crisis](https://www.federalreservehistory.org/essays/asian-financial-crisis).”
>     
> 2.  Hong Kong Monetary Authority. “[How Does the LERS Work?](https://www.hkma.gov.hk/eng/key-functions/money/linked-exchange-rate-system/how-does-the-lers-work/)”
>     
> 3.  International Monetary Fund. “[Indonesia: Country Data](https://www.imf.org/en/Countries/IDN#countrydata).”
>     
> 4.  International Monetary Fund. “[Philippines: Country Data](https://www.imf.org/en/Countries/phl#countrydata).”
>     
> 5.  International Monetary Fund. “[Malaysia: Country Data](https://www.imf.org/en/Countries/MYS#countrydata).”
>     
> 6.  International Monetary Fund. “[Republic of Korea: Country Data](https://www.imf.org/en/Countries/kor#countrydata).”
>     
> 7.  Parliament of Australia, Foreign Affairs, Defence and Trade Group, via ParlInfo. “[Indonesia in Crisis: Economy, Society, and Politics](https://parlinfo.aph.gov.au/parlInfo/download/library/prspub/N7105/upload_binary/N7105.pdf;fileType=application%2Fpdf#search=%22Crisis%20in%20%20Economy,%20Society%20and%20Politics%22).”
>     
> 8.  Stanford University News, via Internet Archive Wayback Machine. “[Dollar/Yen Wars a Lingering Pox on Both Countries’ Houses, Economists Say](https://web.archive.org/web/20220101135801/https://news.stanford.edu/pr/97/971015yen.html).”
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