Introduction banks were not allowed to enter the market or

where their presence was highly regulated.

The financial system is an integral component of
modern economies. In most Asian countries, Financial Repression
commercial banks constitute the primary
component of the financial system. However, “Repressed” financial systems were
characterized by low or negative real interest
informal financial institutions also play an
important role. Furthermore, in the last decade rates and a low and sometimes falling ratio of
monetary assets to GDP/GNP. In a repressed
or so, other financial institutions, including
insurance companies and pension funds, as well system, the government usually plays a
dominant role in controlling the banking system
as stock and bond markets, have gained greater
importance. by imposing these kinds of controls, using banks
to serve as the instruments for allocating credit
Banking and the Financial System to key selected sectors. Often, specialized banks
were created to address the needs of particular
The banking and financial systems in the sectors.
developing economies in Asia evolved from
systems that were in place during the colonial Rural banks were often created for this purpose
period. In South Asia, Taiwan, Malaysia, Hong in the early stages of development and were
Kong and Singapore, the British system was complemented by banks focusing on key
adopted, while in East Asia, the Japanese model industries later in the development process.
was adopted in Korea. In cases such as Thailand
At the same time, credit to other potential
and China, which were not colonized to any
significant extent, the financial system were borrowers was lacking. As a result, informal or
“kerb” markets developed outside the formal
borrowed from the industrial countries.
financial system to mobilize and direct credit to
By the early 1970s, the region as a whole could those sectors not effectively serviced by the
be characterized by the widespread presence of formal financial and banking system.
financial repression. It is a situation, first
The overall impact of these developments was a
described fully by Shaw (1973) and
McKinnon(1973), where government taxes and fragmented banking system where the
organized banking system serviced only a small
subsidies distort the domestic capital market
(compared with a free and competitive system part of the total capital market while informal
finance emerged to serve the needs of other
where private banks are supervised by a central
bank) by imposing interest rate restrictions and borrowers.
high reserve requirements. Financial Liberalization
At the same time there are compulsory credit Designed to remove all the restrictions
allocations to some sectors and the lack of that characterize financial repression. These
credit to others. As a result, loans extended by include the lowering of reserve requirements,
banks were not thoroughly analyzed in terms of freeing up interest rates, and allowing them to
risk or proper viability. Competition among respond to market forces. Managed credit
banks was also limited, particularly as foreign allocations to key sectors should be reduced or
eliminated, and loan officers should be required seemed to offer better rates of return than
to evaluate potential borrowers on the merits lower growth economies in the West.
of the project and not to give loans
Current account deficits. Countries like
indiscriminately based on other economic
criteria. Competitive forces should be allowed Thailand, Indonesia, South Korea had large
current account deficits; this meant they were
to operate in the banking system to improve
economic efficiency through the relaxation of importing more goods and services than they
were exporting – it was a reflection of very high
entry requirements, both domestically and for
international banks. rates of economic growth and consumption.
The current account deficits were financed by
The Financial Crisis of 1997 hot money flows (on capital account). Hot
money flows were accumulated because of
The Asian financial crisis of 1997 refers to a higher interest rates in the East.
macroeconomic shock experienced by several
Asian economies – including Thailand, Fixed or semi-fixed exchange rates. This made
Philippines, Malaysia, South Korea and currencies vulnerable to speculation. Also,
Indonesia. Typically countries experienced rapid interest rates were used to maintain the value
devaluation and capital outflows as investor of a currency. Causing relatively high-interest
confidence turned from over-exuberance to rates in S.E. Asia which caused hot money flows.
contagious pessimism as the structural
imbalances in the economy became more Financial deregulation encouraged more loans
and helped to create asset bubbles. But, the
apparent.
regulatory framework and structure of banking
The crisis of ’97-99 followed several years of and firms meant loans were often made
rapid economic growth, capital inflows and without sufficient scrutiny of profitability and
build up of debt, which led to an unbalanced rates of return.
economy. In the years preceding the crisis,
government borrowing rose, and firms Moral Hazard. With a strong political desire for
rapid economic growth, governments often
overstretched themselves in a ‘dash for
growth.’ When market sentiment changed gave implicit guarantees to private sector
projects. This was magnified by the close
foreign investors sought to reduce their stake in
these Asian economies causing destabilishing relationships between large firms, banks and
the government. This closeness encouraged
capital outflows, which caused rapid
devaluation and further loss of confidence. private firms to place less emphasis on the costs
of projects and an assumption expansion plans
Long-term causes of the Asian Financial Crisis would be supported by the government

Foreign debt-to-GDP ratios rose from 100% to

167% in the four large ASEAN economies in
1993-96. Foreign companies were attracting Over-exuberance. The booming economy and
booming property markets encouraged
capital inflows from the developed world.
Investors in the West were seeking better rates expansive borrowing by firms. It also
encouraged international investors to move the
of return, and the “Asian economic miracle’
capital to these fast-growing economies. There
was an element of irrational exuberance – the
idea that Asian economies were undergoing an
economic miracle where high returns were
guaranteed.

Informal Finance

Informal finance is defined as contracts or

agreements conducted without reference or
recourse to the legal system to exchange cash in
the present for promises of cash in the future.

Informal Financial Sector