What caused the large exchange rate depreciations and stock market declines in some Asian countries during 1997-98? The three main explanations for the Asian crisis emphasize macroeconomic and banking issues. The standard Washington view attributes the Asian Crisis to inappropriate macroeconomic policy during the 1990s, made worse by inept management of the initial depreciation in 1997 (Greenspan, Corsetti, Pesenti, and Roubini). In contrast, Radelet and Sachs and Wade and Veneroso argue that the crisis began with a mild panic that had no real foundation and was made serious only by IMF pressure to increase interest rates and to close down banks. Krugman presents a third theory based on international bank behavior by arguing there was a "Pangloss equilibrium" that caused a bubble in asset prices. In his view, the Asian panics had their origins in implicit (and implausible) guarantees offered by governments and believed by investors.

These explanations agree that for some reason, perhaps unrelated to economic fundamentals, there was a loss of confidence by domestic and foreign investors in all emerging markets. This led to a fall in capital inflows and an increase in capital outflows that triggered, in some cases, a very large nominal depreciation and a stock market crash. The explanations do not address exactly why this loss of confidence had such large effects in some emerging market countries but not others.

This paper presents evidence that the weakness of legal institutions for corporate governance had an important effect on the extent of depreciations and stock market declines in the Asian crisis. By "corporate governance" we mean the effectiveness of mechanisms that minimize agency conflicts involving managers, with particular emphasis on the legal mechanisms that prevent managers from expropriating minority shareholders.

The theoretical explanation is simple and quite complementary to the usual macroeconomic arguments. If stealing by managers increases when the expected rate of return on investment falls, then an adverse shock to investor confidence will lead to increased theft and to lower capital inflow and greater attempted capital outflow for a country. These, in turn, will translate into lower stock prices and a depreciated exchange rate. In the case of the Asian crisis, we find that corporate governance provides at least as convincing an explanation for the extent of exchange rate depreciation and stock market decline as any or all of the usual macroeconomic arguments.

In most of these instances, management was able to transfer cash and other assets out of a company with outside investors.

These assets may have been used to pay the management’s personal debts, or they may have been used to shore up another company with different shareholders, or they may have become straight capital flight into a foreign bank account. The fact that management in most emerging markets is also the controlling shareholder makes these transfers easier to achieve. The downturns in these countries have been associated with significantly more expropriation of cash and tangible assets by managers.