Asian Currency Crisis : A Tale of two Crisis
To date, there are mountains of articles and papers explaining the current Asian
currency crisis. To many, there are contradicting and daunting explanations of what
sparked this crisis. To (really) comprehend (the crisis), it is helpful to look at the crisis
retrospectively. To restore (the crisis), a pertinent perspective of the crisis is inevitable
(in the midst of so many attempts - and sometimes contradictory- to explain its roots).
Here, I attempt to make a comprehensive examination of the roots to this crisis- while
still in line with my previous attempts- by simply showing that this Asian currency crisis
is a repercussion of only TWO crises: (hazardous) private-sector decisions and the
Plaza Accord 1985.
Private-Sector Decisions As a Cause
The Asian Miracle is rested on five pillars: high savings, high investments, 'sound'
macroeconomic policies, strong emphasis on education and sound government. With
the current financial turmoil, the first three of the five pillars are now in question.
In a closed economy, high savings equal high investment. In the past two decades, not
only did many of these countries in Asia (increasingly overtime) boast of some of the
highest saving rates in the world, the phenomenal influx of funds into Asia from the West
gave Asia excessive resources for investment purposes. The latter was based on the
advice of advocates of emerging economies who championed the notion "invest in
Asia or lose out".
This excessively generous and 'blind' lending trend has been singled out as one of the
cause of the current Asian currency crisis. It is a crisis committed by the private sector
and its critics, including the International Monetary Fund, have been actively calling for
fundamental changes to the financial institutions.
A close up examination of this private sector decision making process in lending leads
to three interrelated crises that correspond to three basic and fundamental financial
risks.
Interest Rate Risk
Interest rate risk normally affects both lenders and borrowers. However, when
borrowers borrow short-term and lend long-term, raising interest rates will hit them
particularly hard. These maturity mismatches describe what sparked off the Asian
currency crisis as many companies, corporations and financial institutions have been
borrowing and lending in such manners.
Exchange Rate Risk
To complicate matters, not only did the financial sector practise maturity mismatches
but they were borrowing short in one currency, the US dollar, and lending long in their
domestic currency!
When the country's exchange rate falls sharply against the US dollar, the cost of
renewing or roll over the short-term floating rate dollar in real terms become very high.
This is precisely what happened in Thailand, where the crisis originated, when the Thai
authority un-pegged the fixed link to the US dollar on July 2, 1997.
Competitive Lending Risk
Due to the excessive pool of resources available, many financial institutions in Asian
countries are not only busy lending money to investors and companies (large and
small), they are also fighting competitively to lend to borrowers. From my earlier articles
(for example, Penny Lane- Hazy), I have pointed out that this resulted in funds being
channeled into unproductive areas such as properties and stock markets speculations,
rather than into areas that can help these developing countries improve their standards
of living. For example, building of physical and technological infrastructure, getting rid of
poverty, improving educational achievement for the mass, and to promote them from
developing to developed nations.
When the crisis hit, creditors were reluctant to extend loans as they realised where
these loans were being channeled to, and they began to worry when they could get
back their money!
Hence, a severe credit crunch in the region an amplified overnight as banks
increasingly report bad loans and consequently led close to a freeze-up in banks'
normal lending operations. Companies and corporations were not only unable to find
new loans but had to service past loans in the face of escalating interest rates and fast
depreciating domestic currencies.
When the Bank of Thailand (BOT) decided to float the baht on July 2, 1997, the
contagion effect quickly spread to its neighbouring countries in South East Asia. The
BOT began to fight off speculators by raising interest rates and tightening market
liquidity - a classic textbook response that seems perfectly justifiable. However, upon
closer examination, this response was the very cause of how severe the crisis had
become.
By raising interest rates and tightening market liquidity, they were able to attract dollars
from abroad and also discourage speculators. Theoretically, the higher interest rate
would punish speculators because they are slapped with a higher cost of borrowing the
currency to sell short. The problem, however, is that this seemingly more expensive
borrowing cost comes down to just a pin in the hay on a daily basis when compared to
what they hope to make from even the slightest of devaluation in the currency
speculated.
As a result, raising interest rates in this particular case failed to discourage speculation.
Furthermore, raising interest rates also benefited those who have already sold short
Asian currency in the markets. Thus, speculation was not discouraged but borrowers
were, as they were the ones who suffered as a result of the credit crunch, especially
after higher interest rates and tightened market liquidity were put in place.
Plaza Accord 1985 As a Cause
The Accord
On September 22, 1985, Ministers of Finance and central bankers of G-5 (France,
Germany, Japan the United Kingdom and the United States) met at the Plaza Hotel in
New York. They threw an important initiative to use exchange rates and other
macropolicy adjustments as the preferred and necessary means to bring about an
orderly decline in the value of the dollar. The intention is to curb increasing U.S. trade
imbalances and protectionist action, and to support an orderly appreciation of the main
non-dollar currencies against the dollar. This became known as the Plaza Accord 1985.
Post Accord
This Accord was a milestone as the world's major rich nations agreed to push down the
value of the strong dollar against all other major currencies. Around that time, every
Asian currency was pegged, either formally or informally, to the dollar. The fact that the
dollar took a declining trend against the yen in the post-Plaza era gave a major and
unprecedented boost to Asian exports. East Asian export volumes ballooned by a
staggering 18% a year in the 1990s.
Consequently, these countries also enjoyed and benefited from an influx of capital by
means of increased foreign direct investments. This export boom also accounted for
the massive economic uplifting in history, dubbed "Asian Miracle".
Troubles
This phenomenal boom ended in 1995 when the dollar began to see recovery against
the yen. This meant Asia's exports became relatively expensive, almost overnight and
contributed to Southeast Asia's disappointing export performance in 1996.
But trouble actually took shape prior to 1995. In 1994, China devalued its yuan by as
much as 33% and under-priced its neighbours, Thailand in particular, in the export
market for low-cost goods. Thailand suffered another blow in 1995 when the yen
weakened and undercut Thailand in the high-value goods export markets. To make
things worse for policy-makers, the baht was tied to the U.S. dollar and
the dollar was strengthening from 1995.
Despite all these, Thai foreign reserves looks good and steady, at just below US$40
billion. While exports eroded, foreign direct investments kept pouring in. By 1996,
Thailand owed foreigners as much as US$106 billion and its cash outflow exceeded
inflow by 8% of the country's gross domestic product. In sum, the Thai economy was
nothing but a big bulging bubble waiting to burst anytime, and it did in July 1997. The
rest of the story, we are but only familiar.
Conclusion
The first crisis stated singled out private sector decisions as the main culprit but the
latter points to policy-makers as well. The former blames the government for doing too
little while the latter blames the government for doing too much.
In the former, it is important for us to remember that there are two faces to a loan- the
borrower and the lender. While borrowers have misallocated resources into speculative
and unproductive areas, lenders have to be blamed for providing these loans in the first
place. This is where the authorities come in. But alas! They did not. Many Asian
governments scored badly on the record card when it came to financial markets
supervision and regulation. They dared to deviate from the standard practices of the
West on the notion that everything "seems" fine, not aware that much of the good times
were masked by the design of the Plaza Accord- which ironically, was designed to
benefit them in the first place.
A significant departure from other economic crises in history is the fact that we are now
witnessing markets tumbling economies, instead of vice versa. It underscores that this
is in fact a crisis of confidence and it is only through the restoration of confidence would
we see investors return with the badly needed capital these economies need. Thus, a
overhaul is pretty much needed, in establishing improved regulatory and supervisory
system of the financial sector, improved corporate governance and enhanced
transparency of corporations (banking sector in particular). With these in place, private
sector decisions can be executed efficiently and effectively, for better and not for worst.
Vanson Y W Soo
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