After the Asian Financial Crisis : Can Rapid Credit Expansion Sustain Growth ? PACIFIC BASIN

Thailand each have sought to generate economic recovery by expanding domestic credit.The rapid credit expansion in both countries has created concerns about the extent to which their economies can channel these funds efficiently and sustain economic growth. In particular, if banks are unable to supervise the allocation of resources effectively, there is a risk of widespread bankruptcies and a financial system crisis. Previous experience shows that these Asian economies indeed may be at risk of a credit boom and bust cycle. This Letter discusses the sustainability of the credit-led economic expansions in South Korea and Thailand. First, it discusses the experiences of South Korea and Thailand as they attempted to recover from the 1997–1998 crisis and boost domestic demand through credit expansion.Then, it assesses the risks that these two countries may face if their credit-led expansions collapse and discusses steps they are taking to reduce exposure to these risks. Boom and bust In the decades before the Asian financial crisis, South Korea and Thailand experienced sustained economic growth based largely on export-oriented policies, productivity gains, and investment growth, which was financed by relatively high levels of private saving as well as by foreign borrowing. The rapid expansion of foreign borrowing is seen by many as the primary cause of the Asian financial crisis. Because the financial sectors of the affected countries proved to be too weak to monitor the effective investment of foreign credit, funds were directed to unproductive projects. Consequently, international creditors lost confidence, prompting higher costs of borrowing, and leading to a wave of bankruptcies among many seemingly sound firms. This further undermined international investor confidence, and led to a rapid outflow of short-term capital and a sharp depreciation of domestic currencies.The ensuing crises led to the collapse of the financial sector and of economic activity. During the Asian crisis, South Korea and Thailand were hit very hard, as their economies experienced large and prolonged output collapses: In South Korea, output fell by 8% between 1997:Q4 and 1998:Q2 and did not return to its pre-crisis level until 1999:Q2; in Thailand, total output fell by 14% between 1997:Q3 and 1998:Q3 and did not return to its pre-crisis level until the end of 2000. In addition , consumption and investment contracted sharply in both countries.The International Monetary Fund (IMF) implemented severe austerity packages as part of bailout programs that reduced government outlays and severely curtailed social programs. The long-term cost …