ANALYSIS OF THE ASIAN CRISIS

INTRODUCTION

• An analysis of the East Asian crisis.

The East Asian crisis started in Thailand in 1997 and spread to other parts of East Asia - South Korea, Philippines, Indonesia,and Malaysia. It also had a huge impact on the United States, Japan, Russia, and parts of South America. It affected stock markets, currency values, asset prices, government relations with domestic as well as international institutions,and social impacts.

• A brief overview of how East Asia was before the crisis

Before the crisis triggered in Thailand in 1997, East Asian countries were developing economically as well as socially. They were known as the " Asian Tigers" and were the principal examples for other developing nations. These countries were doing so well economically as well as socially that people had high expectations for them. Hence foreigners were investing huge amounts in these countries which lead to an increase of capital inflow and an increase in current account deficit. They also had a high domestic saving rate.

Financial figures, before the crisis

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Source: [http://www.virtual-asia.com/ph/bizpak/reports/images/image040.gif services growth before the crisis

OVERVIEW OF EXCHANGE RATES

• Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency.
• Exchange rate allows us to denominate the cost or price of a good or service in a common currency.
• Depreciation is a decrease in the value of a currency relative to another currency.
• Appreciation is an increase in the value of a currency relative to another currency.

THE FOREIGN EXCHANGE MARKET

• It is the financial market where exchange rates are determined.
• Participants of the foreign exchange market are:

1. Commercial banks and other depository institutions: transactions involve buying/selling of bank deposits in different currencies for investment.
2. Non-bank financial institutions (pension funds, insurance funds) may buy/sellforeign assets.
3. Private firms: conduct foreign currency transactions to buy/sell goods, assets or services.
4. Central banks: conduct official international reserves transactions.

WHY A CRISIS OCCURS?

According to Herbert Stein the current account and the trade balance of a country is sustained by the changes in exchange rate, inflation rates, real income and interest rates.The current account is a measure of the country's net exports and services. The excess of imports over exports is referred to as a current account deficit.In a prospering country that has highly profiable investment opportunities, if its domestic savings is not enough to finance these activities, it will lead to an inflow of foreign capital. Thus,to be able to invest in the country, foreigners will want to hold the domestic country. This will lead to an increase in the value of the currency's exchange rate. As the value of the currency increases, the country's exports will be more expensive and imports cheaper. This will then lead to a current account deficit. In order to counter the current account deficit, the government of a country will buy foreign currencies with their domestic currency. To finance this purchase, they will print more money to increase their money supply. As a result, there will be either an increase in real income or price level. Real income will increase if there is an equal increase in the domestic production and the purchasing power of citizens. On the other hand, price level will increase if people are willing to pay more money for the same good(s). Either of the effects will lead to and increase in the current account deficit because imports will exceed exports.This may also draw more capital to finance investment to meet the increase demand in the country. In normal conditions, an increase in money supply will lead to an increase in prices in the short run. But in the long run, the price level will eventually go back to the equilibrium level. In case of East Asia, the price level did not go back to equilibrium in the long run. This is because the marekts were not functioning well.

TIMELINE OF THE EAST ASIAN CRISIS

TIMELINE OF THE ASIAN CRISIS

Countries that were a part of the East Asian Crisis:

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Source:World Map

CAUSES OF THE ASIAN CRISIS

Unsustainable current account deficits.

Current account shows international transactions that involve currently produced goods and services. It also includes the net receipts that arise form investment income, the purchase and sale of services and unilateral transfers (gifts, pensions and foreign aids) . One of the main causes of the East Asian crisis was a current account deficit. This means that there was more inflow than outflow of capital. Before the crisis, the East Asian economies were booming. This phenomenon attracted foreign investors whose financial contribution lead to an increase in capital inflow. This capital inflow, mainly short term, was enormous and had a huge impact on their economy and also increased their exposure to outside shocks. The liberalization of capital flow lead to over borrowing, exchange rate instability, and made them less competitive in the international market.

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Source:The 18th annual worlshop in International Studies-Interdisciplinary Approaches to Global Trade

Over-dependence on short-term foreign funds.

The large inflow of capital lead to the banks of the East Asian economies to rely on foreign investors for funds. This lead to an accumulation of debt especially in large corporations. Their reliance on short term loans made its riskier for these economies and increased their chances of getting into a crisis.Short term loans have a maturity duration of one year or less. This means that these borrowing institutions would have to make sure that they have enough liquid assets to be able to pay off their loans within the next year. Taking advantage of the fixed exchange rates, this is exactly what they did. At the same time these East Asian financial institutions are investing more and more in their own economies with the expectations that they will continue to boom. This continued to the point that the behaviour resulted in negatively effecting their returns.

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Source:The 18th annual worlshop in International Studies-Interdisciplinary Approaches to Global Trade

Poor regulation of the economy.

The banking system in Asia was very poorly regulated which allowed unsafe and fraudulent relationships to develop. This gave rise to adverse selection and moral hazard problems. For example, owners of institutions engaged in risky lending and with easy access to funds, uncertain and risky investments were made. Also, the South Asian governments were very corrupted. South Asian societies were very hierarchical and banks would never refuse to lend to the high-class people; even if it was to finance a risky venture.

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Source:The 18th annual worlshop in International Studies-Interdisciplinary Approaches to Global Trade

Furthermore, the governments of these Asian countries did not regulate the amount of capital inflow.

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Source:The 18th annual worlshop in International Studies-Interdisciplinary Approaches to Global Trade

Over-inflated asset prices.

There was an exaggerated increase in the money supply at a fast rate, making it difficult for the economy to adjust accordingly. This unusual growth in money supply lead to large scale lending and increase in investments in risky assets. As Robert Chote said, “ In Asia this excessive risky lending fuelled asset price inflation, creating a virtuous circle: risky lending drove up the prices of risky asset, which made the financial condition of the intermediaries seem sounder than it was, which in turn encouraged and allowed them to engage in future risky lending.”(reference)

Macroeconomic policy: Fixed exchange rates.

Asian countries had fixed their currencies to the dollar. By maintaining the peg with the depreciating dollar, the governments of the Asian Tigers also effectively depreciated their currencies against third part currencies. The cost of imports for the South East Asian nations increased whereas their export prices fell in the Japanese market, their major trading partner. (reference) There was a decrease in export due to the appreciation of the dollar against the yen.Basically, in a fixed exchange rate system, an appreciation or depreciation of the dollar will have a huge impact on those currencies that are pegged against it. There was a decrease in export due to the appreciation of the dollar against the yen.

THE CRISIS

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Source:The 18th annual worlshop in International Studies-Interdisciplinary Approaches to Global Trade

Until 1997, there was huge inflow of capital to East Asia for investment in its highly profitable ventures. The high interest rates that they offer further increased the demand for their currency. The huge current account deficits, the large amount of short term loans,and unregulated financial sector decreased the expectation of the people. Both foreign and domestic investors sought to decurease their holdings of the domestic currencies of these Asian countries which triggered the crisis. In 1996 and early 1997, there was massive selling of the Thai bhat by both foreign and domestic investors. This speculative attack nnd fall in their stock market lead to affecting other East Asian countries such as Philippines, Malaysia, Indonesia, HongKong, and South Korea. In early 1997 the induatrial conglomerates in Korea, known as the chabeol (example: Kia motors, Hanbo steel)went bankrupt and it negatively affected their economy as it was highly dependent on them. Beginning July 1997 Thailand, Malaysia and Philipppines abandoned its currency's peg against the dollar. Philippines imposed foreign exchange controls to keep their currency from depreciating further.Indonesia increased its domestic interest rate in the beginning of August 1997 and then decreased towards the end of the same month becuase it devalued its rupiah on the 14th of August 1997.Also, in the same month Thailand received a financial aid from the International Monetary Fund (IMF) which amounted to $17.2 billion . In August 1997, the Hong Kong dollar also came under speculative attack.By mid October 1997, some of these East Asian countries experienced high currency devaluations. At the same time, the Hong Kong dollar was again under speculative attack.For example, the Hong Kong interest rate was raised overnight to 280%. Indonesia's situation was getting worse. In order to alleviate the difficult economic situation, the IMF provided a $42.3 billion financial aid package to Indonesia on the 5th of November 1997. The IMF gave another $58.2 billion aid to South Korea. Beginning 1998, there seemed to be some stabilization in the East Asian countries. But the condition worsened in May 1998 which brought about anothe phase to the crisis. The situation worsened not only in East Asia but by then, it had also spread to other parts of the world such as Russia, Brazil and West. In May 1997, the economic situation of Indonesia lead to political instability which resulted in the resignation of President Suharto. A new president was also elected in Philippines. In June 1998, the Hong Kong dollar went under speculative attack for the third time. The government of Honk Kong then intervened in the market to save their currency to defend peg. By June and July 1998, the crisis spread to Latin American countries. For instance,Brazil's government authorities enforced economic rigidity in order to avoid a currency devaluation. They also increased short term interest rates from 19% to almost 50%.The stock markets in the West also fell by approximately a quarter of their value in mid 1998. One cause of this was the surfacing of difficulties in Russia wherein Western Europe channeled their funds. To help in their crisis, the IMF then extended a loan to Russia which amounted to $5.6 billion dollars and there was also a 100% overnight increase in interest rate in Russia. In August 1998, the Hong Kong dollar is under speculative attack, for the fourth time and the government invested $8.8 billion to defend their currency. During the same time, there was also a devaluation of the Russian ruble wherein exchange rate controls were forced. This lead to a fall in the western market.Meanwhile, in September 1998, Malaysia which was experiencing financial difficulties as well imposed financial controls.

EXAMPLES

THAILAND

In case of Thailand there were three main factors that attracted foreign capital in the country. They were: 1) High profit margins in stocks. 2) High interest rates 3) Relatively low risk due to its currency being pegged against the dollar.

After the crisis, there was a reversal of this flow in Thailand because people’s expectations in the currency decreased. Thailand was hit by massive speculative attacks in May 1997. Their then Primeminister Chavalit Yongchaiyudhdid not want to devalue their currency against the dollar i.e change their exchange rate. So the then government floated their currency. They also used their foreign reserves to protect the currency, further weakening their economy. This then lead

There was financial liberalization. A significant step towards it was the establishment of the Bangkok International Banking Facility in 1993. This was established to facilitate international lending and borrowing. As the interest rate offered by this bank was 4-6% lower than other banks on dollar borrowing, it was very popular among private investors and other investing institutions. The popularity of this bank grew so much in a short period of time that in 3 years time, the amount lent through that bank rose from $0 to $31.2 billion. In the short term this was good for the country as it helped increase productivity. But in the long run, it was very harmful. It was harmful because there was lack of regulation of the financial institution which made investments very risky. Furthermore, the existing fixed exchange rate system lead to an increase of capital inflows. Thus there was an increase in money supply which resulted in over inflated asset prices and there was more investment in risky sectors.

Korea

By the end of 1997, Korean as well as foreigners did not want to invest in the Korean market because their expectation about the return on the won had decreased. As a result, many Korean businesses went bankrupt. The bankruptcies were due to corruption and the decrease of the Korean market share in markets such as the automobiles where the prices had been overestimated. Foreigners wanted to pull their wealth out of the country before it was too late. As a result, many investors converted the won into dollars. This had a negative effect on the Korean economy; the harm could not even be reversed by the action of the Korean government who tried to help better the situation by using its reserves. As a result, the won depreciated a great deal. For example, companies that could reimburse their debts when a dollar cost 900 won could not do so when one dollar was equal to 1400 won.

EXCHANGE RATE IN KOREA

IMF AND THE CONTROVERSY BEHIND IT

The IMF provided financial assistance to the East Asian countries to help reform their financial system. Along with the aid that they provided, countries were required to practice certain rules and regualtions that could or could not have been beneficial. The IMF gave a total value of $112 billion to Indonesia, Thailand,and Malaysia. The recipients of financial aid from the IMF were required to reform their fiscal and monetary policies. In addition there was also a restructuring of financial institutions such as more regulation of financial isntitutions and forced closing of unprofitable ones. The IMF policy of large interest rates increase was critisized because it may have worsened the situation by increasing debt. It was also bad for failing businesses as it lead to earlier closures.

OVERALL IMPACT OF THE ASIAN CRISIS

According to the Chief International Economist of the investment bank Goldman Sachs, Gavyn Davis: " The loss of global financial wealth in the three month following peak in July 1997 was 2.3 trillion dollars that is a lot of money by annybody's standards which was equivalent to 19% of OECD consumers expenditure, so it was a big hit to world wealth. As far as I can see, there have only really been two episodes like this in the 20th century, The first being 1929 and the second 1987.Partly in response to this we have, like most others, revised our forecast down for world GDP very substantially" (Source:Gavyn Davis (Chief International Economist of the investment bank Goldman Sachs), in oral evidence to the Treasury Select Committee of the House of Commons, 21st October 1998.) The crisis effected western economies by the reduction in both trade flows and foreign direct investment.There was also a decrease in the equity market. A negative wealth effect was caused to foreign investors because of the fall in South East Aisa's equity markets.The extent of damage that it caused depended on the amount of holding or size of the holdings of foreign investors in South East Asia. In addition, there was also a decrease in international trade due to the income effect. This means that East Asian countries were unable to import western goods because of the devaluation of their currencies. This lead to a decrease of import demand thus affecting its trading partners.

CONCLUSION

• A financial problem in one country can have huge devastating effects.It can transcend geographical borders.
• People; their expectations and demands drive the economy.
• PREVENTING A FUTURE CRISIS
• The IMF also creaed a frmework to make "the architecture of the international monetary system" stronger. They were:

1)Reinforcing international and domestic financial institutions

2)Strengthening IMF surveillance.

3)Promoting more widely available and transparent data on member countries' economic situation and policies

4)Underscoring the central role of the IMF in crisis management

5)Increasing the involvement of the private sector in forestalling or resolving financial crisis.

(Sources: Eahan Karunatilleka,Feb 11 1999, "The Asian Economic Crisis", Economics Policy and Statistics Section, House of Commons Library and IMF, Annual Report 1998, Chapter VII, 1998, pp 48-50)

• As suggested by Chancellor Gordon Brown's, the system in which the IMF, and the World Bank at Bretton Woods were, was updated which were,

1)Improving global regulation, which would involve the IMF, the World Bank and other regulators forming a new, permanent standing committee for global financial regulation.

2)Creating a process of active and transparent surveillance of borrowing nations

3) Creating a code of best practice on social policy issues so that financial crisis if they do occur, do not result in disproportionate increases in poverty within developing countries.

(Sources: Eahan Karunatilleka,Feb 11 1999, "The Asian Economic Crisis", Economics Policy and Statistics Section, House of Commons Library and Gordon Brown, "Rediscovering Public Purpose In The Global Economy", speech delivered at the Kennedy School, Harvard University, 15 December 1998.

SOURCES

• Paul Krugman's Unofficial Page
• WIKIPEDIA-The Free Encyclopedia
• The Asian Economic Crisis
• Herbert Stein
• Paul Krugman and MAurice Obstfeld,2006,International Economics Theory and Policy,7th Ed
• Frederic S. Mishkin,2006, Economics of Money, Banking and Financial Markets 7th Edition