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 affectes 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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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.

CHRONOLOGY OF EVENTS OF THE EAST ASIAN CRISIS

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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 WORKSHOPS IN INTERNATIONALSTUDIES - 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.

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 WORKSHOPS 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.

SOURCES

• Krugman's articles
• Wikipedia
• House of Commons research paper
• Economics of Money, Banking and Financial Markets
• International Economics Theory and Policy
• Articles from the United Nations Development Program
• Herbert Stein, Jan 16, 1998, "It seems to me. Reading about Korea. What the newsapers don't explain about Asia's currency problems." LINK