September 10, 2011 September 10, 2011 Report Report South East Asian Crisis South East Asian Crisis INTRODUCTION The South East Asian financial crisis was a period of financial crisis that gripped much of Asia beginning in July 1997, and raised fears of a worldwide economic meltdown due to financial contagion. The crisis started in Thailand with the financial collapse of the Thai Baht caused by the decision of the Thai government to float the Baht, cutting its peg to the USD, after exhaustive efforts to support it in the face of a severe financial overextension that was in part real estate driven.
At the time, Thailand had acquired a burden of foreign debt that made the country effectively bankrupt even before the collapse of its currency. As the crisis spread, most of Southeast Asia and Japan saw slumping currencies, devalued stock markets and other asset prices, and a precipitous rise in private debt. Though there has been general agreement on the existence of a crisis and its consequences, the exact reasons of this financial crisis are still debatable. South East Asian economies had maintained high interest rate which promised high return rate for foreign investors looking for investment.
Regional economies Thailand, Malaysia, Indonesia, Singapore and South Korea experienced 8-12% GDP growth in the late 1980s and early 1990s. US $184 billion entered in the developing countries during 1994-96 according to the Bank of International Settlements. In the first half of 1997 $70 billion came in but in 2nd half of 1997 (Onset of crisis) this inflow suddenly turned into outflow of US $102 Billion, creating a wide spread panic among the investors and governments alike. Key Drivers of South East Asian Crisis:
Economists believe that the South East Asian crisis which mainly affected Thailand, Indonesia & South Korea was created not by market psychology, but by policies that distorted incentives within the lender-borrower relationship. * Unregulated Financial Liberalization: East Asia’s economic growth was mainly the result of capital investment, leading to growth in productivity. Most of these countries had carried out a process of financial liberalization where foreign exchange was made convertible with local currency not only for trade and direct investment but also for autonomous capital inflows and outflows.
This facilitated large inflow of funds in the form of international bank loans to local banks and companies, purchase of bonds and portfolio investment in local stock markets. However, as argued by Notable economist Paul Krugman, only growth in total factor productivity, and not capital investment, could lead to long-term prosperity. * Local asset boom, bust and liquidity squeeze: Owning to excessive real estate speculation the high amount of investment flowed from different countries in Thailand which resulted into a bubble.
This bubble needed more and more money as its size grew. The short term capital flow was expensive and often highly conditioned for quick profit. Also, under the ambience of the corrupt government, the development money went in a largely uncontrolled manner to certain people only, not particularly the best suited or most efficient, but those closest to the centres of power. * Currency depreciation: At the time, there was a huge build-up of short term debt among the countries most affected.
What transformed this into crisis for Thailand, Indonesia and South Korea was the sharp and sudden depreciation of their currencies, coupled with reduction of their foreign exchange reserves in anti-speculation attempts. When the currencies depreciated, the burden of debt servicing rose significantly in terms of the local currency amount required for loan repayment. * Competition in export: Another reason for this crisis was competition from china due to its export – oriented reforms in 1990s.
China had begun to compete effectively with other Asian exporters particularly in the 1990s after the implementation of a number of export-oriented reforms. Most importantly, the Thai and Indonesian currencies were closely tied to the dollar, which was appreciating in the 1990s. Western importers sought cheaper manufacturers and found them, indeed, in China whose currency was depreciated relative to the dollar. Lessons for the developing countries from the Asian crisis: 1.
Need for great caution about Financial liberalization and Globalization One of the most important lessons from the Asian crisis is that it is prudent and necessary for developing countries to have measures that reduce its exposure to the risks of globalization and thus place limits on its degree of financial liberalizations. In a globalized world, developing countries often face tremendous pressures coming from developed countries, international agencies, transnational and national companies to completely open up their economies.
It is proven that liberalization can and has played a positive role development, however; the Asian crisis has shown up that in some circumstances, liberalization can play havoc, especially on small and dependent economies. This is more so prominent in the field of financial liberalization, where lifting of controls over capital flows can lead to such extreme results as a country accumulating a mountain of foreign debts within a few years, the sudden sharp depreciation of its currency, and a sudden rush of foreign owned and local owned funds out of the country in a few months. So, Developing countries should exercise caution while deregulating their external finances and foreign exchange operation so rapidly when they are unprepared for the risks and negative consequences. * Measures should be adopted to prevent any speculative inflows and outflows of funds, and to prevent opportunities for speculation on their currencies. 2. Manage external debt well and avoid large debts Another great lesson learned from the Asian crisis is that developing countries should not build up large foreign debt, public or private debt, even if they have relatively large export earnings.
The East Asian countries were big exporters and perhaps this led them to the complacent belief that that the future growth is comfortably sustainable through the years and would provide the cover for a rapid buildup of external debt. However, the crisis proved that high current exports earnings are insufficient to guarantee that large debts can be serviced. It is so for obvious reasons: * Future growth export can slow down as it did during the crisis * There can also be a high growth in imports and a large outflow of funds due to repatriation of foreign owned profits or due to the withdrawal of short term speculative funds.
In good times, these factors can be offset by large inflows of long term foreign investments, however; if negative factors outweigh the inflows, the country might run out of foreign reserves and might default on its debt obligations. It is thus important for a developing country to watch the relation of levels of debt and debt servicing not only to the export earnings but also to the level of foreign reserves. 3. Manage and build up foreign reserves
The careful management of foreign reserves has emerged as a high priority policy objective for a developing country in the wake of the Asian crisis. Unfortunately, this is one of the most complex and difficult task for any emerging economy, simply because there are so many factors involved such as the movements of exports and imports, the servicing of debt and repatriation of profits, the inflows and outflows of short term funds, the level of foreign direct investment and inflow of foreign loans.
All these items are components of the balance of payments, whose bottom line determines whether there is an increase or run down of a country’s foreign reserves. On the one hand, an emerging economy needs inflows of long term investment and long term loans in order to provide liquidity and build reserves. And on the other hand, there is the difficult problem of how to manage short term capital flows. A developing country must carefully manage policies so as not to cause large future outflows on account of problems of profit repatriation and of debt repayment. . The need for Capital controls and a Global debt workout system The Asian crisis exposed the great lack of international mechanism that comes to the rescue of a country facing severe problems in external debt repayment. A mechanism that includes the declaration of a debt standstill by countries in trouble, with a system in which creditors give the affected countries time to restructure their debts and economic activities in an orderly debt workout is badly needed.
A major lesson of the Asian crisis is thus that the capital controls should be an important component of the array of policy options employed by developing countries in order to protect their interests and to enable a degree of economic stability. 5. Market is unpredictable, can make mistakes and needs regulation The Asian crisis shattered the myths of perfect markets and its efficient use of resources.
In the pre-crisis era, it was widely believed that financial liberalization and private sector borrowing would not pose problems as banks, investors and companies would have calculated accurately their credit, loan and investment decisions. However, the crisis proved that markets and private sectors are imperfect, as seen by the huge inflows and then sudden outflows of foreign funds, by the imprudent large external loans taken by the local companies and banks which they were unable to repay. So, one of the lesson for the developing countries is that they have to be prepared for abrupt changes within the global system.
East Asian economies enjoyed such buoyant growth in 1990s, that they at time became complacent and everything achieved on the trade was ruined overnight because of the lack of financial rules, wherein funds rushed around and destroyed the confidence in their currencies. Asian Crisis – Then and Today: Many years after the Asian crisis, it is quite natural to ask: what were the lessons, and has the world learned them – especially the developing countries? Could such a crisis recur? What hasn’t changed? 1. Lack of transparency: The workings and movements in the international financial markets played the most important part in the Asian crisis.
It became obvious that the global system needed reforms and discipline, yet there is a great lack of transparency on what constitutes the financial markets, who the major players are, what are their decisions and how money is moved from market to market, and with what effects. Financial crises cannot be prevented or resolved unless there is a greater transparency in financial markets. 2. Pressure to liberalize capital markets: Developing countries need capital to grow, and if domestic resources are lacking then capital can only be tapped from four foreign sources – aid, loans, remittances and FDI.
So, there is a huge pressure on developing countries to open and liberalize their capital markets so that investors will flock to build projects. The goal of a country’s economic policy makers, in theory, should be to create growth for their economies, while the goal of foreign investors is, indubitably, to make profits. These two goals seldom align and create pressure on policy makers to focus inordinately on just attracting FDI risking the country’s long term growth prospects. It was large capital inflows to the countries with weak financial and corporate regulation laid the ground for the outbreak of financial crisis in Asia.
Following table list the average of some of the key attributes for the countries that went into the crisis and the countries that didn’t. | Countries that faced crisis | Countries that did not face crisis| Short term debt to reserve ratio| 1. 82| 0. 41| Total debt to reserve ratio| 2. 31| 0. 825| 3 year change in private credit to GDP ratio| 0. 17| 0. 024| Capital inflow to GDP| 0. 07| 0. 059| Current A/C balance to GDP| -0. 05| -0. 131| 3 year % change in real interest rate| -15. 82| -16| Corruption Index| 3. 22| 3. 6| 3.
Short term debts in foreign currencies: International banks engage in short term lending to emerging markets simply because longer maturities carry greater risks and thus – shorter the term of loan, the lower the interest rates. For a developing country, short term borrowing provides the advantage of lower interest rates and thus many governments in developing countries still encourage short term loan. However, short term debts are pro-cyclical in developing countries – increasing when economic growth is faster and declining when growth rates falter.
So, of the different types of capital flows, short term loans are the most likely to be withdrawn during difficult times. 4. Lack of a credible international financial institution: The need for a credible and disciplined financial institution to design the policies and regulations in a way that enhances the global stability and promotes consistent economic growth in developing countries was quite evident after the crisis. But the present system (IMF) dominated by US and Europe, suits the interests of financial lenders and speculators.
Nevertheless, it is becoming daily more evident that the present system is very unstable and will continue to produce large scale crisis. What has changed? 1. Foreign currency reserves: Most developing countries have accumulated massive foreign currency reserves. They learned the hard way what happened to the countries otherwise during the Asian crisis, as the IMF and US Treasury marched in, took away economic sovereignty and demanded policies intended to enhance repayment to Western creditors, which plunged their economies into deep recessions and depressions.
Even though the foreign reserves are costly for a developing country, for the money could have been spent on development projects that would enhance growth; the benefits in reducing the likelihood of another crisis and another loss of economic independence far outweigh this cost. 2. Increased debt in local currencies: Most of the developing countries have also increasingly started borrowing in their own currencies during the last few years, thus reducing their foreign exchange exposure.
For those developing countries that remain heavily indebted abroad, an increase in risk premium would almost certainly bring economic turmoil, if not crisis. But the fact that so many countries hold large reserves means that the likelihood of the problem spreading into a global financial crisis is greatly reduced. Summary: The South East Asian financial crisis has taught the world the lesson that there are great risks for developing countries when they are asked to liberalize their economies too fast, or to take part in globalization in an indiscriminate way.
Opening the economy when the country is not prepared to withstand the shocks generated by the world economy, or when its local companies and industries are not prepared to compete with giant international corporations, can cause significant disruption. The developing counties must have sound national fiscal policies and strong institutions to manage the interface between the domestic and external economies, even as the pressure mounts on the developing countries to open up even more to the big companies of the developed countries.
Alongside, international reforms are still needed – including an overhaul of the global reserve system and for the setup of a credible international financial institution. Even though we may not be facing a repeat of the Asian crisis, the developing countries must make no mistake as imperfections in the global financial system can still be costly – both in terms of prosperity and economic stability. References: 1. http://en. wikipedia. org/wiki/1997_Asian_financial_crisis 2. ttp://www. un. org/esa/policy/pastmeetings/degefe. pdf 3. http://mostlyeconomics. wordpress. com/2010/07/19/fiscal-austerity-lessons-from-south-east-asian-crisis-dont-do-it/ 4. http://www. slideshare. net/pujil2009/what-is-south-east-asian-currency-crisis 5. http://www. thecsem. org/content/south-east-asian-crisis 6. http://www. thirdworldtraveler. com/Economics/LearningSEAsiaCrisis_DS. html 7. http://www. tradingeconomics. com/ *********************