International Finance: Case: Asian Currency Crisis 1997 Essay
In mid 1997, a financial crisis gripped most of the Asian countries and raised fears of a worldwide economic meltdown due to a financial contagion, a scenario that initially affects only a particular region of the economy that spreads to other countries whose economies were healthy, much like a transmitted disease. See, Asia attracted almost half the total capital inflow into developing countries because of the high interest rates maintained by the Southeast Asian economy, it attracted foreign investors looking for a high rate of return.
Due to this, the economies received large amounts of money and experienced a dramatic run-up in asset prices. For the past couple of decades then, no other group of countries has produced not only such a rapid economic growth but also a dramatic decrease in poverty in the entire world. Korea, Malaysia and Thailand virtually eliminated hardcore poverty while Indonesia was close to reaching that target. Per capita income levels increased in Korea, Thailand and Malaysia – tenfold, fivefold and fourfold respectively, while that of Singapore and Hong Kong had exceeded that of some Western industrial countries.
This was touted to be the “Asian economic miracle” by IMF and the World Bank. Noted economist Paul Krugman argued that while Asia’s economic growth is the result of increasing capital investment, total productivity had only marginally increased, if not at all even, stating that only growth in total factor productivity, not capital investment, could lead to long-term prosperity. And when the crisis hit, his views were seen as prophetic. Though there has been general consensus on the existence of this crisis, what is less clear is the cause of it.
Firstly, politics could have had a hand in it in what is called crony capitalism. With all the inflow from investors, development money went out in an uncontrolled manner to certain people who were possibly not best suited or most efficient of the lot to handle the investments, but only because of the ties between them and those in power. This happened not only in Malaysia, but in our neighbouring countries Indonesia and Thailand as well. Or secondly, it could even have originated in the mid-1990s when the US raised its interest rates to head off inflation in order to recover from a recession from the early 1990s.
When this happened, investors saw the US as a more attractive investment in comparison to Southeast Asia, and at the end of the day, raised the value of the US Dollar. For the Southeast Asian countries with currencies pegged to the US Dollar, the increase caused their own exports to become more expensive thus less competitive in global markets. At the same time, our export’s growth slowed dramatically, deteriorating to its current account position then.
Standard economic indicators revealed large macroeconomic imbalances such as export growth slowing markedly, current account deficit was persistently large and was financed increasingly by short-term inflows, and the real exchange rate appreciated to a level that appeared unsustainable. It is all these problems that then uncovered other weaknesses in the economy: substantial unhedged foreign borrowing by the private sector; inflated property market; and an over-exposed financial system. These weaknesses reflected undisciplined foreign lending, unfavourable movements in the currency-to-Dollar rate, and weak domestic policies.
The latter was said to be the cause of it all. Last but not least, the Asian currency crisis was due to policies that distorted the incentives within a lender-borrower connection. The inflow of money that became available generated a high leveraged economic climate which pushed up asset prices to an unsustainable level. When the prices began to collapse, individuals and companies defaulted on debt obligations. The ensuing panic led to a hefty withdrawal of credit from the crisis countries which cause a credit crunch and bankruptcies.
On top of that, as foreign investors attempted to withdraw their money, the exchange market was swamped with currencies of the crisis countries, leading to a depreciative pressure on their exchange rates. To prevent the currency values from collapsing, these countries raised domestic interest rates to extraordinarily high levels in order to diminish flight of capital. In addition, to intervene in the exchange market, the governments bought up any excess domestic currencies at the fixed exchange rate with foreign reserves. These policy responses could not be sustained for long.
While it already can be extremely damaging to a healthy economy, very high interest rates wreaked havoc on these fragile Asian economies. And during this time, central banks throughout Asia were losing foreign reserves of finite amounts. When it became apparent that the capital was fleeing anyway, authorities ceased defending their fixed exchange rates and, in turn, allowed their currencies to float. This resulted in those currencies’ values being depreciated, which meant that foreign currency denominated liabilities grew considerably in terms of domestic currencies, causing more bankruptcies and further deepening the crisis.
Thus are the three main origins of the Asian Currency Crisis. Question 2 What role did the expectations play in the Asian currency crisis? Expectations were one of the downfalls of the Asian economy because some assumptions made proved to be false and worked negatively against them. For example, the Asian’s banks and financial institutions’ expectation that the governments will bail them out in case and risk undertaken defaulted proved to be faulty and ultimately led to the burst of the Asian bubble when governments failed to do so and investors fled.
Another example of expectation playing a role in the crisis is in the appreciation of U. S. Dollar and the depreciation of Yuan. Asian banks had financed themselves with dollars because they expected that the currency will remain stable. Thus, when the Dollar appreciated more than 50% against Yen and 20% against the German Mark led to the loss of competitiveness, greatly accelerated by the depreciation of the Chinese Yuan (25% against U. S. Dollar) at the same time, which had come unexpectedly. Question 3
How did the appreciation of the US dollar and depreciation of the yuan affect the timing and magnitude of the Asian currency crisis? Prior to the crisis, most the East Asian countries pegged their currency to the currency of their most prominent trade partner; the United States. The markets in the East Asian countries were bullish at the moment, attracting foreign capital with their high interest rates. The peg to the US dollar helped to keep inflation at a relatively low rate and promoted currency stability, well into mid 1990s.
At the same time the depreciation of the US dollar against the Japanese yen assisted the increase in the exports of the East Asian countries The currency stability achieved through the pegging of the East Asian currencies to the US dollar resulted in massive, short-term, foreign financing by East Asian banks in terms of US dollar, yen and Deutsche marks. This was due to the cheaper cost of capital attained because of the low interest rates in the United States, Japan and Germany. However, when the US dollar began recovering in 1995 the currency began appreciating against other currencies such as the Japanese yen.
The appreciation of the US dollar happened at a time when, as stated above, the East Asian countries were borrowing massive amounts of short term foreign capital. This led to the beginning of the crisis as the new foreign interest rate difference made these short term loans relatively more expensive than they were before. The recovering of the US dollar has also deepened the magnitude of the crisis as it has led to the loss of export competitiveness of the East Asian countries. Their exports are now relatively more expensive than the exports of other countries such as China.
The depreciation of the Chinese yuan against the US dollar by approximately 25% has made Chinese goods and services cheaper than the exports of East Asian countries. This resulted in a significant loss of income for East Asian countries, gained through exports. Central banks in East Asian countries responded by devaluing their currencies in an attempt to increase the competitiveness of their exports. However, this created panic within the markets of the East Asian countries which was then followed by huge capital fleeing as a consequence.
This in return created the bulk of the problem faced by the East Asian countries during the crisis. Question 4 What is moral hazard and how did it help cause the Asian currency crisis? As economic crises come and go at more frequent intervals, the response of governments and financial institutions alike is always at the forefront of discussions. We often hear the term ‘moral hazard’ being thrown into the mix whenever government intervention is sought or proposed and whenever bailouts are discussed.
The concern regarding ‘moral hazard’ is one that is rightfully so as it may lead to negative consequences especially considering the behaviour of economic players that can trigger devastating effects; this was, in fact, the case with the Asian currency crisis. Moral hazard is a term that aptly originated from the insurance industry. It is the tendency to alter ones behaviour to one that behaves differently when a party is insulated from risk than it would if it were fully exposed to risk. The tendency is to incur risk when one protected against it.
It arises due to parties not taking full consequences and responsibilities of its actions. Financial intermediaries whose liabilities are backed by the government have long been known to be perpetrators of moral hazard. In the context of the Asian currency crisis, this very situation is thought to be one of the major causes that exacerbated the crisis. While explicit guarantees were not made, several reports have indicated that financiers of Thai finance companies, South Korean banks and the likes were protected from risk.
An example cited by Krugman (1998) was Thai finance companies having guaranteed liabilities, thus protecting all depositors in those institutions. Strengthening this perception is the fact that crony capitalism was rife throughout the affected countries. Many lending and investment decisions were dictated by the strong political connections of the owners of financial institutions. The well-connected benefited from easy-money loans and risky behaviour and this resulted in overinvestment. The factors above resulted in massive lending to companies and industries, mostly influenced by crony capitalism, with little regard for profitability.
Not only do they undertake excessively risky investments, but with the protections afforded, they would also pursue investments with low expected returns. The strong prospects of massive losses were ignored as they were insulated from losses, instead focusing on the minute possibility of gain as the owner of the financial intermediary is well aware that he can benefit from the high returns or can easily walk away from the losses in the worst-case scenario. While a blind eye can be turned so long as government guarantees are in place, the dream only lasts until verything falls apart. When crisis hits and non-performing loans and widespread loan defaults are exposed, the government is forced to act on its guarantee on a massive scale. Failing to do this will cause plummeting asset values and the bubble bursting triggering a chain-reaction of events further aggravating the crisis. When investors realized that governments were not able to make good on their promises and bail out everyone, the panic that ensued from declining asset values caused further loan defaults.
Worrying about negative effects and inflationary measures, investors reacted adversely resulting in accelerated capital flight and a falling currency. Speculation on falling currency also resulted in firms demanding for more foreign currency, putting further pressure on an already crashing currency. At this point, Asian central banks found them-selves in a classic catch-22 position as attempting to raise interest rates would also worsen the problem as the cost of funds made it difficult to service debts.
Krugman (1998) further theorizes that the problem of moral hazard in this instance was worsened by globalization and access to world capital markets. This access was said to have spurred overinvestment further by “allowing moral hazard in the financial sector to translate into real excess capital accumulation”. In essence, the illustration above shows how moral hazard was a significant factor in the Asian currency crisis, aggravated by underlying crony capitalism and weak regulatory structures. References Krugman, P. (1998). What happened to asia?. Retrieved from http://web. it. edu/krugman/www/DISINTER. html Question 5 Why did so many East Asian companies and banks borrow dollars, yen, and Deutsche marks instead of their local currencies to finance their operations? What risks were they exposing themselves to? Many of East Asia companies borrow dollars, yen and Deutsche mark instead of their local currencies to finance their operation because these countries are the major importer from the East Asia countries. In addition, currency stability also led East Asia, bank and companies to finance themselves with dollars, yen, and deutsche mark.
It is because dollars and other foreign currencies loan carried lower interest rate than did their domestic currencies. For example, in 1995 the dollars began recovering against the yen and other currencies. By mid 1997, the dollar had risen by more than 50 percent against the yen and by 20 percent against the German mark. The appreciation of the Dollar alone would have made East Asia’s export less price competitive. But their competitiveness problem was greatly exacerbated by the fact that during this period, the Chinese Yuan depreciated by 25 percent against the dollar.
Thus, the lost of export competitiveness slowed down Asia growth and caused utilization expense. This kind of financing has involved with the risks which is in the maturity distribution of accounts. As for maturity distribution, many banks and businesses in the troubled Asian economies appear to have borrowed short-term for longer-term projects. Many economists blame these loans as the major cause that contributed for the Asian crisis. Some of this debt is to finance trade and is self-extinguishing as the trade transactions are completed.
However, these short-term loans have fallen due before projects are operational or before they are generating enough profits that enabling repayments to be made. As long as an economy is growing and not facing particular financial difficulties, rolling over these loans such as obtaining new loans as existing ones mature may not be particularly difficult. It is because it leads the competition become intense among banks. In the Asian case, when a financial crisis hits, the loans suddenly become more difficult to procure, and lenders may decline to refinance debts. At the same time, private-sector financing virtually evaporates for a time.
A structural change in the nature of the borrowing by these Asian countries is that the type of borrowing has shifted away from the government and banks borrowing from international financial institutions such as the World Bank or receiving development assistance funds through foreign aid programs to borrowing by private corporations. After capital markets were liberalized in the newly industrializing countries of Asia, most of the outside funds flowing into these economies were borrowed by the governments (public sector). Now major banks and the non-bank private sector account for most of the borrowing.
In addition, the others risk that they were exposing is moral hazard problem. Most Asian bank and finance companies operated with implicit or explicit government guarantees. For example, the South Korean government directed the banking system to lend massively to companies and industries that it viewed as economically strategic, with little regard for their profitability. When combined with poor regulation, these guarantees distorted investment decisions, and encouraging financial institutions to fund risky project in the expectation that the banks would enjoyed any profit, while sticking the government with any losses.
Besides that, in Asia’s case the problem was compounded by the crony capitalism. It is pervasive throughout the region with lending decision often dictated more by political and family ties than by economic reality. Hence, billions of dollars in easy-money loans were made to family and friends of the well connected and without market discipline or risk-based bank lending, the result was overinvestment and inflated prices of assets in short supply, such as land.