The Asian Financial Crisis of 1997 - 1998 and the Behavior of Asian Stock Markets
by Urbi Garay
paper analyzes the currency and stock market collapses experienced by Hong Kong,
Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan, and
Thailand in 1997 and early 1998. Documented is the close relationship between the
behavior of the stock markets of these countries during this period, and the
evolution of their currencies. Price/Earnings and Price/Book ratios are used to
show that Asian stock markets were not “overvalued” before the crisis
thus suggesting that the crisis was not the result of a bursting bubble. This
paper also describes the different theories of stock market co-movements across
countries, which again become important with the post-crash reduction in the advantages to investors of international
of this paper is twofold. First of all, it reveals that the stock market collapses
experienced by a number of South East Asian economies in 1997 and early 1998
where highly correlated with the evolution of the currencies of the countries
involved. Secondly, using Price/Earnings and Price/Book ratios it is shown that
Asian stock markets were not “overvalued” before the crisis started; thus
suggesting that the crisis was not the result of a bursting bubble that some
authors such as Krugman have argued.
paper also presents the different theories of stock market co-movements across
countries. The presence of contagion or inter-dependence among economies of a
certain region become important with the diminishment of the advantages to
investors of international diversification, via increases in cross-correlations
among stock market returns. The issue of international contagion and
inter-dependence has been in the forefront of academic discussions as a result
of Mexico’s 1994 and Asia’s 1997-'98 financial crises.
In the second section of this paper the behavior of S.E.-Asian currencies during the crisis is analyzed. The rest of the paper is organized as follows: the third section analyzes the evolution of S.E.-Asian stock markets during the crisis; the fourth section inquires whether Asian stock markets were “overvalued” before the financial crisis erupted; the fifth section presents the different channels of transmission through which the stock market of one country might be influenced by the evolution of other stock markets; and, finally, the sixth section summarizes and presents the author's conclusions.
2. The Evolution of Asian Currencies During the Financial Crisis
Asian financial crisis started with the devaluation of Thailand’s Bath, which
took place on July 2, 1997, a 15 to 20 percent devaluation that occurred two months after
this currency started to suffer from a massive speculative attack and a little
more than a month after the bankruptcy of Thailand’s largest finance company,
Finance One. This first devaluation of the Thai Baht was soon followed by
that of the Philippine Peso, the Malaysian Ringgit, the Indonesian Rupiah and,
to a lesser extent, the Singaporean Dollar. This series of devaluations marked the
beginning of the Asian financial crisis.  This first sub-period of
the currency crisis took place between July and October of 1997. Figures 1A and
1B (below) present the monthly evolution of the currencies of the eight South-East Asian
countries studied here for the period July 1997 (rebased to 100 in all the
graphs) to May 1, 1998.  Included are the Hong Kong (H.K. Dollar),
Indonesia (Rupiah), Malaysia (Ringgit), the Philippines (Peso), Singapore (SG
Dollar), South Korea (Won), Taiwan (New Dollar) and Thailand (Baht).
second sub-period of the currency crisis can be identified starting in early
November, 1997 after the collapse of Hong Kong’s stock market (with a 40
in October). This sent shock waves that were felt not only in Asia, but also in
the stock markets of Latin America (most notably Brazil, Argentina and Mexico).
In addition to these stock markets, were those of the developed countries (e.g.
the U.S. experienced its largest point loss ever in October 27,
1997, which amounted to a 7 percent loss). These financial and asset price crises also
set the stage for this second sub-period of large currency depreciations. This
time, not only the currencies of Thailand, the Philippines, Malaysia, Indonesia
and Singapore were affected, but those of South Korea and Taiwan also suffered.
In fact, the sharp depreciation of Korea’s Won beginning in early November added
a new and more troublesome dimension to the crisis given the significance of
Korea as the eighth largest economy in the world; the magnitude of the
depreciation of its currency which took place in less than two months; and the Korean
Central Bank’s success in maintaining the peg ever since the Thai’s first
devaluation (i.e. the “nominal anchor” of the largest of the Asian Tigers was
suddenly lost). In addition, was the other important component of this second
sub-period: the complete collapse of the Indonesian Rupiah that
started at about the same time.
starting in January of 1998, the currencies of all of these countries regained
part of what they had lost since the crises started. It is also important to
note that at a great cost Hong Kong was able to maintain its peg after the
crisis first erupted. This required that interest rates be raised to fend-off these currencies
from repeated speculative attacks.
3. The Evolution of Asian Stock Markets During the Asian Financial Crisis
necessary to study the evolution of the stock markets and the inflow of money
that went to the Asian economies in order to understand the financial crisis of
1997- 1998. Net equity investments in the economies of South Korea, Indonesia,
Malaysia, Thailand, and the Philippines amounted to US$ 12.2 billion in 1994, US$
15.5 billion in 1995, US$19.1 billion in 1996, and US$ –4.5 billion in 1997
according to the
Institute of International Finance in 1998. The reversal for 1997 came as a
result of the financial crisis that started in Thailand, which added pressure to
the currency markets of the countries considered in this article. Net equity investments and new
private loans financed most of the increasing current account deficits that the
SE-Asian economies, as well as most of the developing world, experienced during
the 1990s. The ability of most of the developing world to import capital through
securities markets was enhanced by the exponential growth in the U.S. mutual
fund industry, and the low interest rates available in the U.S. and Japan during
the past decade.
Now, through the following figures, let us turn our attention to the behavior of the Asian stock market indices during the crisis.
Figures 2A and 2B (above) show the monthly evolution of national stock price indices (expressed in US dollars) for these same eight countries and during the same period of time. The stock market indices are those provided by Morgan Stanley International Capital (MSCI). Figures 3A and 3B (below) show the behavior of the same Asian stock market indices from January 1997 to May 1998 but expressed in local currency. As can be seen, the direction of the stock markets is similar to that of Figures 2A and 2B in which the indices where expressed in US$ terms. However, the magnitude of the decline on the local stock market prices is not as pronounced when expressed in local currency.
Figures 3A and 3B (above) show the behavior of the same Asian stock market indices from January 1997 to May 1998 but expressed in local currency. As can be seen, the direction of the stock markets is similar to that of Figures 2A and 2B in which the indices where expressed in US$ terms. However, the magnitude of the decline on the local stock market prices is not as pronounced when expressed in local currency. This finding suggests the existence of a currency effect affecting stock price returns during the crises, as is explained in the next paragraph.
finding of a close relationship between exchange rate depreciations and stock
returns during a crisis is consistent with Bailey, Chan and Chung (2001). These
authors demonstrate, using intraday data, that the severe downturn of the
Mexican stock market in December 1994 and early 1995 can be associated with the
Peso devaluation that took place during this same period. In the case of the
five Asian countries whose currencies experienced the sharpest depreciations
during the Asian crisis (Indonesia, Malaysia, Philippines, South Korea, and
Thailand) the average correlation between weekly stock market
returns and currency changes (where currency is defined as the number of units
of foreign currency per 1 U.S. dollar) between the first week of July 1997 and
the first week of May 1998 is –0.63 and is significant at the 1percent level.
My explanation for this strong association is that currency devaluations have
traditionally been accompanied by declining stock markets in the developing
world because they have usually taken place in the middle of a financial crisis
and uncertainty about the future course of economic policies and outcomes. For
instance, the negative impact of devaluing currencies on S.E.-Asian banks and
companies that had borrowed heavily on international markets most probably
surpassed the potential export gains. But an “orderly” devaluation such as that
of Britain in 1992 did not have negative effects on the London stock market
since it helped the British economy recover from a three-year recession via an
Stock Markets “Overvalued” Before the Crisis Started?
The stock markets of Hong Kong, Indonesia, and South Korea fluctuated with no clear trend before the first sub-period of the currency crisis began in early July, 1997. The stock markets of Malaysia, Singapore, the Philippines, and Thailand drifted downward during this same sub-period, with the later two countries experiencing the sharpest declines. Finally, Taiwan's stock market drifted upwards during this same sub-period of time. Therefore, I not see any evidence of a clear pattern of stock markets collapsing in a contagious fashion before the first round of devaluations took place in July, 1997, as Krugman (1998) suggested was the case: 
And then the bubble burst. The mechanism of crisis, I suggest, involved that same circular process in reverse: falling asset prices made the insolvency of intermediaries visible, forcing them to cease operations, leading to further asset deflation. This circularity, in turn, can explain both the remarkably severity of the crisis and the apparent vulnerability of the Asian economies to self-fulfilling crisis –which in turn helps us understand the phenomenon of contagion between economies with few visible economic links.
checked the evolution of the same national stock market indices since 1991 (the
preceding five years to the crisis) and, on one hand, I found a significant
increase in Hong Kong’s stock market asset prices (a fourfold increase),
the other hand, the remaining seven stock markets stayed remarkably flat, with
some minor fluctuations. Furthermore, the performance of the Asian stock markets
lagged behind the Latin American, the British, and the United States stock
markets during the same years prior to the crisis. Thus, it seems hard to
contend that the collapse of the stock markets in South East Asia was the result
of a bursting bubble, since the stock prices of the markets of SE-Asia had
hardly any growth six years prior to the currency crises of 1997.
To analyze whether rapidly increasing stock prices represent a bubble; financial economists try to express these prices in terms of indicators such as; the earnings of companies which trade stocks in the market (the P/E or Price/Earnings ratio, and the P/B or Price/Book ratio.) Rising stock prices and earnings may well yield a flat P/E ratio (i.e. there is no bubble since higher stock prices are justified by “fundamentals”, at least as it pertains to the P/E ratio.) For instance, authors like Gilibert and Steinherr (1996) contend that the rise in stock prices that took place in Mexico in the early 1990s was the product of a speculative bubble and that it was not justified by fundamentals. However, analyzing P/E and P/B ratios of Asian stock markets just before the crisis erupted it is difficult to contend that these markets were “overvalued” since the ratios were below the world average (See Table 1 above.)
Table 2 (above) shows that the U.S. stock market had been, on a risk-adjusted basis, the
best market performer during the period 1990-96, followed by Latin America,
U.K., Asia (excluding Hong Kong), and Japan. The fact that S.E.-Asian markets
plummeted after having lagged behind the performance of those of the rest of the
world, and after having remained relatively flat during the 1990s (i.e. no
bubble), is another indication of how severe and dramatic the financial crisis
Krugman’s assertion is nonetheless consistent with the behavior of national stock prices in South East Asia after the first round of devaluations. Such evolution had actually preceded the second and more intense wave of devaluations of November and December of 1997. This is because, as was shown in Figures 2A and 2B (above), between the first and second round of devaluations the stock markets of Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand experienced sharp declines. Not until the currencies of these countries stabilized in early 1998 were their stock markets able to reverse the downward trend in stock prices (except in Indonesia).
summary, it is difficult to contend that falling stock prices during the Asian
crises were the result of a bubble that was bursting or that Asian stock markets
were “overvalued” before the crisis first erupted.
5. Stock Market Co-Movements: The Channels of Transmission 
In this section the literature of the determinants of stock market co-movements is briefly examined.
stock market co-movements occur? What are the linkages among stock markets that
can explain a crisis such as the Asian? Calvo and Reinhart (1996) provide a
brief summary of the existent explanations in the context of currency crisis, 
and in this paper an attempt is made to adapt some
of these explanations to the case of stock market co-movements during
periods of financial crises, a sub-area in this field that has received
relatively little attention.  Nonetheless, the inflow
of capital to the developing world that took place in the late 1980s and early
1990s was accompanied by an increasing share of portfolio investments as local stock markets became increasingly open towards foreign investors. Such
is the case for the Latin America countries where this situation is presented
more frequently than in the South Eastern Asia countries.
Stock market co-movements can be explained as follows:
reason is that stock market co-movements may take place when the financial
markets of two countries are highly integrated so that shocks to the larger
country are transmitted to the smaller ones via assets-trading. An example of
this type of spillover is the integration of the capital markets of
Argentina and Uruguay. As a result of Argentina’s 2001-2002 severe crisis and
subsequent external debt default and currency devaluation, Uruguay has recently
been forced to devalue its currency.
second most important reason are the trade partners and bilateral or
multilateral trade arrangements that enhance the possibilities of international
shocks. For instance, when the currency of a country experiences a large real
depreciation, imports from its trading partners fall, and the trade balance of
the country whose currency is devalued deteriorates, thereby setting the stage for
the currencies of its neighbors to suffer speculative attacks if the impact is
large enough. For example, the Brazilian devaluation of 1999 placed great
pressure on Argentina’s currency, Brazil’s most important trading partner.
third reason (See Chua, 1993.) emphasizes the role of technological factors on
economic growth. Technological spillovers between neighboring countries tend to
occur because ideas and capital flow are faster and easier across neighboring
countries rather than across distant countries. Thus, the economic growth of a
country is affected by the economic growth of its neighbors. I have found a
highly significant and positive regional spillover effect in a number of the
South East Asian countries.
first three theories or reasons presented above attempt to explain stock market
co-movements as a consequence of economic linkages among countries. These
theories are what Forbes and Rigobon (2000 and 2002) might call
interdependence explanations. Nevertheless, the last three theories or
reasons, which are of a contagious nature, deal with the effects of investor’s behavior on
stock markets, the result of which may cause a stock market crisis or exacerbate
an existing one.
The fourth reason, is that spillovers or contagious crises may occur for institutional reasons according to the theories of Calvo and Reinhart (1996) theories: 
In response to a large adverse shock (such as the Mexican devaluation)  an open-end emerging market mutual fund that is expecting an increasing amount of redemptions will sell off its equity holdings in several emerging markets in an effort to raise cash. However, given the illiquidity that characterizes most emerging markets, the sell-off by a few large investors will drive stock prices lower. Hence, the initial adverse shock to a single country gets transmitted to a wider set of countries.
The fifth reason is that investor’s sentiments can generate self-fulfilling crises if foreign investors do not discriminate among different macroeconomic fundamentals across countries. There exists a vast literature on banking and financial crises in the developed world in which the issue of contagion effects arise frequently. According to Calvo and Reinhart, for example:
In the wake of a bank failure (particularly a large of prominent bank), anxious depositors possessing imperfect information about the soundness of other banks rush to withdraw their deposits from the banking system at large. The stampede by depositors generates a liquidity crisis that spreads to other healthy banks. Thus, herding behavior by depositors alters the "fundamentals" for a broader set of financial institutions and the crisis becomes self-fulfilling...A similar story can be told about investors in international currency and equity markets...With regards to emerging markets, however, relatively little is known about these issues.
sixth reason is that contagion may occur because of the way market participants
interpret possible co-movements in macroeconomic policies and fundamentals in
the economies subject to attack. [Eichengreen, Rose, and Wyplosz
the experience of currency crisis being accompanied by stock market collapses in
the developing world (The figures shown above confirmed this in the context of the
SE-Asian financial crises), a speculative currency attack against one currency
and the concomitant effects may well trigger simultaneous declines in the stock
markets of these same countries.
this paper the currency and stock market collapses experienced by a
number of South East Asian economies in 1997 and mid 1998 have been examined, and the
close relationship between the behavior of their stock markets during this
period and the evolution of the currencies of the countries involved was
analyzed. Shown was that the severe downturn of the Asian stock markets during the financial crisis
can be associated with the currency devaluations of the five countries whose
currencies experienced the sharpest depreciations during the crises, especially
in the case of Indonesia, Malaysia, Philippines, South Korea, and Thailand. This
was reflected in an average correlation between weekly stock market returns and
currency depreciations of –0.63 during the crisis period.
the evolution of South East Asian stock markets prior to the crisis was analyzed there
was no evidence found of a clear pattern of stock markets collapsing in a
contagious fashion before the first round of devaluations took place in July,
1997 as Krugman (1998) suggested was the case. Krugman’s assertion is
nonetheless consistent with the behavior of national stock prices in South East
Asia after the first round of devaluations occurred. Also, the fact that South
East Asian stock markets plummeted after having lagged behind the performance of
those of the rest of the world, and after having remained relatively flat during
the 1990s (i.e. no bubble), is another indication of how severe the financial
market co-movements may occur for different reasons. First, they may take place
when the financial markets of two countries are highly integrated so that shocks
to the larger country are transmitted to the smaller ones via assets-trading.
Second, trade partners and bilateral or multilateral trade agreements enhance
the transmission of shocks internationally. Third, spillover effects may be the
result of technological factors or economic growth. Fourth, contagious crisis
may occur for institutional reasons. Fifth, investor’s sentiment can generate
self-fulfilling contagious crisis if foreign investors do not discriminate among
different macroeconomic fundamentals across countries. And sixth, contagion may
occur because of the way market participants interpret possible co-movements in
macroeconomic policies and fundamentals in the economies subject to attack.
though I did not test any of the theories of contagion in this article, I am inclined to think that “competitive” devaluations were present during the crisis
and that a domino effect was created when international mutual funds sold Asian
stocks and bonds of both crisis and non-crisis countries in an effort to raise
cash. These two channels of transmission correspond to the second and fourth
theories of contagion outlined in the previous paragraph.
I conclude that contagion or interdependence across stock market returns diminishes greatly the
advantages of international diversification highlighting the instability of
historical correlation coefficients among stock market indices when a crisis
W., Chan, K., and P. Chung, “Depositary Receipts, Country Funds, and the Peso
Crash: The Intraday Evidence,” The Journal of Finance, (Dec. 2002), v55,
n6, pp. 2693-2717.
S., and C. Reinhart; “Capital Flows to Latin America: Is There Evidence of
Contagion Effects,” in Calvo, Goldstein, and Hochreiter, Private Capital
Flows to Emerging Markets after the Mexican Crisis (Vienna: IIE, 1996.)
H.; “Regional Spillovers and Economic Growth,” Center Discussion Paper
No. 700. New Haven, CT: Yale University Economic Growth Center.
B., Rose, A., and Ch. Wyplosz; “Contagious Currency Crises,” National Bureau
of Economic Research Working Paper 5681, 1996.
K., and R. Rigobon; “Contagion in Latin America: Definitions, Measurement, and
Policy Implications,” NBER Working Paper No. 7885, 2000.
K., and R. Rigobon; “No Contagion, Only Interdependence: Measuring Stock Market
Co-movements,” The Journal of Finance, (Oct. 2002), v57, n5, pp.
P., and A. Steinherr; “Private Capital Flows to Emerging Markets after the
Mexican Crisis,” in Calvo, Goldstein, and Hochreiter, Private Capital Flows
to Emerging Markets after the Mexican Crisis (Vienna: IIE, 1996.)
Finance Corporation, Emerging Markets Factbook (Washington: The World
P.; “What Happened to Asia?,” Unpublished Manuscript, 1998
Patel, S., and A. Sarkar; “Stock Market Crises in Developed and Emerging Markets,” Federal Reserve Bank of New York Working Paper, 1998.
1. The author would like to thank Gerald Epstein and B>Quest referees for very helpful comments. The usual disclaimer applies.
2. China’s 1994 40 percent devaluation and the Japanese Yen’s 25 percent depreciation between 1995 and 1996 weakened the competitive position of the rest of the countries of the region and set the stage for the round of competitive devaluations that took place in the middle of 1997.
3. The source of the data is Datastream.
5. It is beyond the scope of this study to attempt to test any of the theories presented in this section.
6. The literature on the subject of currency crises is vast. A widely cited paper in this area is Eichengreen, Rose, and Wyplosz (1996). Using thirty years of panel data from twenty industrialized countries, these authors find evidence that speculative attacks tend to be temporarily correlated and that currency crises seem to pass from one country to another. The authors also conclude that an important variable explaining these currency co-movements was the existing linkages of international trade between the countries affected.
9. The authors refer to the large devaluation of the Peso that took place in December 1994 and early 1995.
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