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The collapse of the Thai baht extended well beyond levels seen on the first day of “flotation”. Having been around THB25 to the US dollar before the “flotation” (devaluation), it subsequently fell to a low of 56.3 in the coming months, a decline in value of over 40%. In the case of the Indonesian rupiah, the fall was even more spectacular, plunging from IDR2,300 to the dollar to a low of 17,000, a devaluation of 85%! Asian countries generally tightened monetary policy in order to temper the threat of imported inflation from currency devaluations and in line with the IMF’s initial call for tightening of both fiscal and monetary policy. Policy tightening in the face of maxi-devaluation of the currency tends to cause a slowdown in the economy to become a recession (if not a depression!), and in the cases of Thailand and Indonesia that is indeed what happened. In 1998, the Thai economy contracted 9.5%, while that of Indonesia contracted 13.2%. Whatever the merits of these policies, which were ostensibly aimed at providing long-term economic stability, there is no question that in the short term they severely exacerbated the regional economic slowdown. At street level, millions were forced into poverty. The World Bank estimated that half of Indonesia was living in a state of absolute poverty in 1998, defined as earning less than USD1 a day. Unemployment levels skyrocketed. Retail prices rose sharply to offset the free-falling currency in the likes of Indonesia, the Philippines and Thailand. Interest rates were tightened to offset this, compounding the misery.
In the wake of this, several leading commentators were heavily critical of the IMF policy response to the Asian crisis, saying the combination of tight fiscal and monetary policy represented a worse cure than the disease itself. While I have some sympathy with this view, particularly as public policy adjustment is not necessarily the appropriate policy response to private sector imbalance (too many Asian companies borrowing too much in dollars and speculating too much in their own stock and property markets), this still does not answer the question of how one stops a currency from free-falling. This is a key consideration bearing in mind that the collapse of the rupiah resulted in the bankruptcy of almost every company in Indonesia. Whether you favoured the argument of the IMF’s Herbert Neiss or Harvard’s Jeffrey Sachs, it is pretty irrelevant. By then, the damage was already done; the battle had already been lost. By then, it was a question only of damage limitation.
The example of the Brazilian crisis, however, suggests some refinements to the standard IMF policy response have been considered — not least at the IMF — in the wake of the Asian crisis. When the Brazilian real devalued in January 1999 and subsequently fell to a low of 2.2200 to the dollar from its 1.20 band level, many forecast 2.50 or even 3.00 and a similar type of recession to that Asia had experienced. In reality, neither of those two possibilities happened. Clearly, the appointment of Arminio Fraga as the new head of the Brazilian central bank was an important stabilizing measure, as Fraga was a widely respected figure in the financial markets. The maintenance of trade finance for Brazil was also a crucial difference.
Whatever the differences, the similarities between the crises in Asia and Brazil — and also with Mexico, Russia and Turkey — are clear. Most notably within this was the fact that once inflation peaked so too did local interest rates, allowing for a substantial rally in asset markets and the currencies themselves. In Indonesia, for example, this meant interest rates coming down from around 75–80% and the dollar–rupiah exchange rate falling back from around 17,000 to around 6500. Equally, in Thailand, the dollar–Thai baht exchange rate fell back from 56 to around 35. In the case of Brazil, the dollar–Brazilian real exchange rate fell back from 2.22 to 1.63. Fundamentally, during this period, the trade accounts in many Asian countries swung from significant deficits to massive trade and current account surpluses.

A pegged currency that is allowed to float freely usually falls sharply for at least the first six months after the free float is put in place, overshooting any idea of fair value. The rule is the longer a central bank tries to defend it, the further the currency falls in the end. Currency market participants who earlier dismissed the idea of currency risk have to chase the market to put belated hedges in place. In addition, at the macroeconomic level inflation rises as the pass-through effect to the real economy of maxi-devaluation. The signal that the devaluation is at an end is when that inflation rate peaks. At that time, portfolio money starts to flow back into the country, attracted by high nominal interest rates. This in turn allows the local currency to recover potentially significant ground. In line with this, the trade account improves significantly as import demand collapses in the wake of economic contraction. Thus a liquidity-based rally in local asset markets and the local currency is created through lower interest rates and renewed portfolio inflows. This is different from Phase IV, which sees a fundamentally-based rally, as demand-side indicators continue to deteriorate during this period.