Financial Crisis in Asia:
Political and Security Implications


Executive Summary: The financial crisis in Asia threatens to interrupt decades of strong economic growth, leaving many to reassess their views on the Asian miracle’s achievements up until now, and its future prospects. While investors are fleeing Asia, international institutions like the IMF and the World Bank have arrived with bailout packages and policy prescriptions in an attempt to contain the economic crisis. For political and security observers, the crisis in Asia is viewed as a disturbing development that could potentially spark numerous socially-destabilizing trends throughout the region: instability on the Korean peninsula caused by a financially strained South Korea; massive unemployment throughout Asia with potentially destabilizing social and political consequences; a possible reduction in defense spending among key American allies in the region; and heightening tensions in Taiwan-China relations that could invite an American response, among others. The financial crisis is analyzed from an economic perspective, beginning with an overview of the foundations of the crisis, the mechanism of the crisis, and why the crisis was not foreseen. These economic explanations serve as a foundation for exploring the impact of the crisis on political and security relations in the region.


I. Introduction

As the crisis in East Asia continues to unfold in 1998, vexing questions persist: What contributed to the regional financial turbulence? What is the extent of the crisis? Why was it not foreseen? What is the impact of these crises on domestic political stability, and in turn, on regional security in the Asia Pacific? How will defense planning and security sectors in the region be affected by these new economic constraints? In a region where leaders have built their political legitimacy on a foundation of strong economic performance, economic stability and regional security are fundamentally intertwined—and are now facing a perilous term of uncertainty. What role can—and should—the United States play in the unfolding crisis?

U.S. Pacific Command and the Asia-Pacific Center for Security Studies conducted an Asia-Pacific Economics and Security Conference in Honolulu on 12-13 January 1998, bringing together top security and economic experts to explore these and other relevant issues and to contribute to a U.S. Pacific Command perspective on the unfolding crisis and its implications for international relations and regional security. The conference was structured into two major lines of inquiry: the causes and scale of the economic crisis and its long-term security and political implications.

II. Economic Assessment of the Financial Crisis in Asia

Analyzing the financial crisis from an economic perspective was usefully laid out by studying the technical and multidimensional problems, beginning with an overview of the foundations of the crisis, the mechanism of the crisis—how the crisis played out from a market perspective—and why the crisis was not foreseen. This session also assessed why some countries may have escaped, in relative terms, the kind of financial turmoil experienced by their neighbors. Experts concluded the session with a discussion of what could be next for the region economically, and what policymakers should—and should not—expect from Asia.

Foundations of the Crisis

Follow-on Effects of Appreciating Currencies and Capital Outflows: During the mid-1980s, the increasing value of the yen undercut export competitiveness in Japan. Thus, Japanese companies were forced to find cheaper production sites offshore, leading to large capital outflows from Japan to South Korea and some Southeast Asian countries.

Politicized, Institutionally Weak Financial Systems: Asset market bubbles began developing in the late 1980s in these countries due to poorly regulated banking sectors and institutionally weak financial systems. These systems—plagued by strong state intervention—were corrupt and highly politicized.

1995 Mexico Bailout: The U.S. bailout of Mexico in 1995 created a moral hazard problem, as it sent a signal to international investors that unwise investments in the future would also be protected.

Mechanism of the Crisis

Fixed Exchange Rates Encouraged Borrowing Abroad: Since exchange rates in Asia were linked to the dollar in Asia, companies borrowed abroad with no concerns for the risk of currency fluctuations.

Exports and Profits Decline: Export growth began to fall in 1996 due to a drop in the export prices of key products (semiconductors, cars)—caused by an overcapacity of such commodities in the global market. The drop in export prices undermined profit expectations of companies across Asia.

1994 China Devaluation: When China devalued its exchange rate in 1994, the devaluation undercut the export competitiveness of Southeast Asian economies and put pressure on the Thai and Indonesian currencies. Some economists, however, urged that the devaluation not be overplayed as a factor in the crisis.

Domestic and Foreign Investors Move Funds Offshore: In response, domestic and foreign investors found shares of these companies to be less attractive and thus, began moving their money out of these markets. This exerted downward pressure on Asian currencies.

Fixed Exchange Rates Abandoned in the Face of Capital Flight: As investors abandoned these markets en masse, governments across the region were finally forced to allow their currencies to depreciate. Uncertainty and a lack of credible information about the scope of problems in these countries has prevented investors from returning to the region, despite the bargains generated by devalued currencies and deflated stock markets.

Why Was the Crisis Not Foreseen?

Stresses Were Evident, But the Trigger is Hard to Know: Government leaders, financial analysts, and economic experts were all aware of the asset bubbles in Asia, severe problems in Korea’s financial system, and the extent of bad loans in Japan. Like earthquakes, however, one can identify stresses but still not recognize the trigger mechanism.

Lack of Transparency: The crisis was also difficult to predict because accurate information was withheld from investors by troubled economies. Also, senior government officials themselves, in many cases, were unaware of the extent of their problems.

Potential Problems in the Offing?

China and Hong Kong

Will China Devalue Its Currency? If So, When? A Chinese devaluation could destabilize Thai and Indonesian currencies once more, sending new shock waves through Southeast Asia. With respect to Hong Kong, devaluing its currency could also spark a series of "beggar thy neighbor" policies in the region, making everyone worse off.

Financial Sector Problems: China has a serious bad debt problem, which amounts to about 30-35% of GDP. In addition, private capital flows needed for privatizing China’s state owned enterprises are likely to slow, forcing China to reorder its priorities.


Japan is a Rich, Mature Nation: Japan has a high level of economic maturity—it has essentially achieved a standard of living equivalent to that of the West. Slow overall growth is expected. Thus, Japan’s economic problems are unique from that of its younger Asian counterparts.

"Bad Lifestyle" Habits Are Shared: Japan and other Asian economies share bad economic lifestyle habits, derived mainly from the non-economic allocation of capital and weak competitive forces in the economy. Low returns on capital at home have driven Japanese investors in search of profits abroad, at times leading to unwise investments. Incomplete financial markets and insufficient deregulation are also two other factors which contribute to Japan’s unhealthy economic status.

United States

U.S. Trade Deficit Will Grow, GDP Will Fall: The U.S. trade deficit will grow by $50-100 billion, with much of the increase coming with Japan and Korea. Aggregate GDP growth will drop off by 0.5%-1.0%, to 2.5% in 1998.

Increased Protectionist Sentiment: These events will fuel greater protectionist rhetoric in the Congress, leading to possible backsliding on critical trade policy agenda issues such as a quota increase for the IMF and fast track legislation.

What's Next?

Restoring Market Confidence: Key to ending the crisis is to restore market confidence in the economic policies—and policymakers—in the region.

Mexican Peso Crisis Not a Good Comparison: There are several key differences between the Mexico case and that of Asia. The peso crisis involved one country, not a whole region. Also, the United States was seen as a guarantor of political and economic stability of Mexico. No country has stepped forth to take such a role (certainly not Japan). Thus, Asia’s problems could last longer than that of Mexico’s.

Other Potential Problems: As short term debts continue to become due, roll-over problems will be back. Also, a sovereign default remains an option for countries in Asia. Lastly, Asian economies are likely to continue raising import restrictions in an effort to hoard dollars.

IMF’s Three Scenarios: The IMF’s cautiously optimistic baseline projection is an $80 billion decline in capital flows to emerging markets in 1997 and a partial reversal by 1999. The IMF’s more hopeful scenario projects a containment of the decline to $50 billion; the more pessimistic estimate forecasts a $100 billion decline sustained for five years.

Other Considerations

Is the Crisis Asia’s "Berlin Wall"? Asia will be forced to endure painful reforms unlike anything the region has experienced. Realization has dawned on Asia that ‘things will never be the same’ again. Not only will banks and financial systems be completely revamped, but also the very way in which business is conducted (e.g. the end of crony capitalism).

Different Nations Will be Differentially Successful at Coping: Some countries will reform relatively quickly, while others may take longer. It is possible some economies may never come out of the crisis, much in the same way countries like Argentina remain economic under-performers despite years of effort.

Is the U.S. Up to the Leadership Challenge? The U.S. role in the Asian crisis has been critical, as both investors and troubled Asian economies sought strong leadership—the former for credibility, the latter for a vote of confidence. Congress’ increasing opposition toward the bailouts in Asia, however, may reflect a growing American reluctance to play a major role in the future.

III. Political and Security Implications of the Crisis

This session attempted to explore the impact of the crisis on political and security relations in the region. Experts assessed the impact of the crisis and significant developments employing a country by country analysis of those most affected or likely to be most affected. Criteria used for the country analyses included the prospects, possibilities and risks involved in maintaining domestic stability given the financial shocks placed on political systems across the region. The country analyses were followed by a discussion on congressional reactions to the crisis itself and the U.S. response, and suggestions for policy action.

Prospects, Possibilities, and Risks


The Months Leading Up to Presidential Elections Are Critical: President Suharto’s political legitimacy has been firmly based on uninterrupted growth. The unfolding crisis presents a tremendous test to Suharto’s political viability and to Indonesia’s domestic stability. With presidential elections only two months away, Indonesia is already in a time of uncertainty. While investors and the IMF have called for Suharto’s commitment to painful economic reforms, political analysts are uncertain as to whether the public will stand for the difficult times ahead.

Signs of Domestic Political Instability: Labor unrest and growing anti-Chinese sentiment in Indonesia have spurred fears of domestic instability and the possibility of state disintegration. Because the Indonesian military forces continue to play an influential role in domestic politics, most political experts believe disintegration is unlikely.

Korean Peninsula

Leadership Transition in Seoul: Opposition figure Kim Dae Jung’s recent presidential victory marks a significant shift in Korean political history. If Kim won on a public protest vote against the ruling party’s poor economic management vis-a-vis the financial crisis, the public’s expectations that he deliver on his promises are high. It is unclear whether Kim’s liberal populist platform and traditional ties with labor are strengths or weaknesses. Some may hope for sweeping changes, but his radical past and his urgent need to shore up domestic credibility may constrain him from initiating major reform.

Possibility of North Korean Miscalculation: One effect of the crisis on peninsular security is a possible miscalculation of the financial crisis by Pyongyang. The IMF package to South Korea could encourage the North to extort greater financial support from the international community.

"Dual Hardship" on the Peninsula: A less economically intimidating South could mollify the North’s approach to bilateral talks. Enthusiasm for dialogue in the South, however, may be tempered by trepidation. The consideration of unification as an absorption exercise is likely to go even further on the back burner.

Prospects for U.S.-Korea Relations: Economic crisis is not likely to have a negative impact on the overall U.S.-Korea security alliance. Korea will continue to maintain host nation support. In the short run, the ROK defense budget will decrease, but the impact will be mainly on supplemental purchases (e.g. AWACs).

Tertiary Effects on Security: Seoul will continue to support KEDO, but likely to revisit the cost issue with the United States and Japan in light of its economic straits. South Korea is also likely to revisit the issue of greater autonomy with the U.S. on third country arms transfers.

China/Hong Kong

Looming Possibility of Devaluation: A Chinese devaluation would send new shock waves to economies throughout the region, raising the specter of political instability in Hong Kong and Southeast Asia. Massive capital flight would result.

Implications for Chinese Reform: Chinese leaders had looked to Japan and Korea as models for China’s economic development; that approach is now under challenge. China’s leadership is likely to be more cautious over the short-term as it rethinks domestic priorities. Failure to manage reform of state-owned enterprises effectively could lead to massive unemployment and possible social unrest.


A Strengthened Hand? Taiwan has not been totally immune, but to date it has largely escaped serious damage from the Asian crisis (Taiwan’s stock market has fallen roughly 14% since the onset of the crisis). The strength of Taiwan’s economy offers Taipei a diplomatic opportunity. Taipei has been offering support to weakened Southeast Asia and Korea; it offered a bridge loan to Seoul, for example, in exchange for diplomatic relations. The crisis may raise Taiwan’s profile and strengthen its political ties with the region.

Possible Damage to China’s Integration Strategy: The collapse of Southeast Asia’s currencies may lure Taiwanese investment away from mainland China. If economic ties between China and Taiwan begin to weaken, Beijing’s strategy of slowly integrating the province into a "greater China" economy may stumble—possibly sowing the seeds for greater cross-strait tension.


Political Weakness: Criticism is rampant regarding Japanese inability to lead the region during a time of crisis. Japanese Ministry of Finance is also under fire for misinforming investors about the extent of its own bad debt problems. The crisis has weakened Japan’s role in the region.

U.S. Congressional Reaction

Institutional Oversight: Congressional attention to the Asian crisis will greatly increase in the next few months, as Congress has planned a series of oversight hearings to investigate and better understand the U.S. implications of the crisis in Asia. Experts believe that Congress will exert its influence through the appropriations process, where it will vote on whether to further fund the IMF.

Disillusionment About Asia: An important long term consequence of the crisis is Congress’ disillusionment about Asia. Some experts believe Congress’ positive attention to Asia in recent years was mainly driven by perceptions of the region’s growing economic wealth. In light of the recent economic troubles, its positive outlook on Asia may be in jeopardy. This could undercut the rationale in support for the continued large U.S. military posture in Asia, especially if Asian allies are even less willing than in the past to contribute to burdensharing costs.

Suggestions for Policy or Operational Action

Continued U.S. Participation in Asia: U.S. policymakers must continue to remain engaged and committed to the Asia Pacific region, in both words and deeds. The U.S. must emphasize its interests in the region and the importance of its alliance relationships.

Inter-Agency Coordination Crucial for Coherent U.S. Response: There is a need for greater coordination among the military, diplomatic, and economic aspects of U.S. foreign policy.

U.S. Leadership is Indispensable: The U.S. must stress its understanding of the linkages between economic stability and security, especially with respect to the region. Strong U.S. leadership is "indispensable," especially as it was demonstrated in the U.S. response to the financial crisis.

Trust-Building by Encouraging Cooperation: The U.S. must lead in providing a stable security environment to help foster trust and confidence. This can be done by emphasizing cooperative approaches to problems rather than allowing the region to continue relying on win-lose, "beggar thy neighbor" policies motivated by fear.