The Asian Currency Crisis


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Overview of the Asian currency crisis and the potential for such crisis to occur in other nations including the potential for crisis in the United States. Written in May 2007.

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The Asian Currency Crisis

  1. 1. Megan CrookhamMay 17, 2007IA 216Professor Dube The Asian Currency Crisis The following paper will discuss the causes and implications of the Asian Currency Crisis of1997. The overall aim of the paper is to prove that such an economic crisis could occur again if theproper economic policies are not carried out. An analysis of the economic policies carried out priorto the crisis will be presented in order to demonstrate how and why the crisis came about and how itcould have been prevented. This topic is of particular interest due to the fact that since 1997national markets have become even more integrated and interdependent. If such a crisis were tooccur today it is likely that the effects would be even more severe. In this globalized world noteven developed countries are immune to poor economic policy (Shapiro, 2005, p. 16). As such,countries including the United States should be highly cautious in their economic endeavors andshould take all measures necessary to prevent a future economic crisis from occurring. The Asian Currency Crisis started when Thai businesses began to default on the loans theytook out in order to finance investments in commercial and residential property (Hill, 2006, p. 363,See Figure 1, Appendix A). Excessive investment in property resulted in an oversupply of availablereal estate (Hill, 2006, p. 362). Because the investors were unable to make any profit on the surplusreal estate they could not pay the loans they took out from Thai financial institutions (Hill, 2006, p.363). It was feared that because the investors were unable to pay the Thai institutions that in turnthe Thai lenders would default on their loans from international banks (Hill, 2006, 363). As a resultof this speculation, foreign investors fled the Thai stock market selling their positions andconverting them to dollars (Wong, 1999, p. 392). This led to an increased demand for U.S. dollarsand an increased supply of Thai Baht which pushed down the dollar/baht exchange rate and causedthe Thai stock market to plunge (Hill, 2006, p.363). The dollar to baht exchange rate dropped from$1 = Bt 25 to $1 = Bt 55 by January of 1998 as the Thailand stock market index declined from 787in early 1997 all the way down to 337 by the end of the year (Hill, 2006, p. 363, See Figure 2,Appendix A). The wave of speculation spread to other currencies causing them to be marked loweras well which resulted in an explosion of debt throughout the region and hence an Asian CurrencyCrisis. The crisis was the result of a few factors which when combined ended up creating a deadlyarrangement. The first of the major causes for the crises was the previous decade of unprecedentedexport driven grown experienced by the countries of Southeast Asia. Export grew so much and was 1
  2. 2. Megan CrookhamMay 17, 2007IA 216Professor Dubeso successful from 1990 to 1996 that investors even began to make the transition from exportingbasic materials to exporting more technical products (Hill, 2006, p361). Specifically, the value ofexports from Thailand had grown by 16 percent per year, Malaysia had grown by 18 percentannually, Singapore’s exports grew by 15 percent, Hong Kong’s by 14 percent and South Korea andIndonesia’s exports grew by 12 percent annually (Hill, 2006, p. 361). The high level of success inexports thus encouraged bolder investment and led to an investment boom in commercial andresidential property, industrial assets and infrastructure (Hill, 2006, p. 362). In particular grossdomestic investment grew by 16.3 percent annually in Indonesia, 16 percent in Malaysia, 15.3percent in Thailand and 7.2 percent in South Korea in the years 1990 to 1995 (Hill, 2006, p. 362). In certain Southeast Asian nations the governments encouraged investment in certain areasof the economy in order to reach national goals and as part of the industrialization strategy. Forexample, South Korea urged investment in new factories to boost growth but these “diversifiedconglomerates” borrowed heavily, some of them creating debts up to four times their equity (Hill,2006, p. 362). In Indonesia crony capitalism prevailed in the economy limiting competition throughthe creation of monopolies (Hill, 2006, p. 362). Banks in Indonesia as a result were forced to giveloans for potentially risky investments such as auto production. The overarching theme here is thatthe mid 1990s investment boom was financed with borrowed money and gross domestic investmentin the countries of Southeast Asia was higher during this time period than in any other (Wong,1999, p. 393). As the number of investments continued to increase, the quality of investmentsbegan to decline. To make matters worse, many of these long term investments were carried outusing short term loans (Wong, 1999, p. 393). Eventually these investments which were made basedon unrealistic projections of future demand conditions resulted in significant excess capacity.Excess capacity resulted in plunging prices on everything from property to semiconductors (Hill,2006, p. 362). Another major factor behind the crisis was the fact that the countries of Southeast Asia hadpegged their currency to the US dollar (Wong, 1999, p. 393). Investors borrowed in US dollarsbecause interest rates on dollar borrowings were less than rates on domestic currency.Unfortunately, as excess capacity began to drive prices down, the governments of the affectedcountries could not maintain the dollar peg and their currencies started to depreciate against thedollar (Wong, 1999, p. 392). This was not helped by the fact that inflation was higher in Southeast 2
  3. 3. Megan CrookhamMay 17, 2007IA 216Professor DubeAsia than the U.S. (Hill, 2006, p. 363). This drove up the debt burden when measured in localcurrency and resulted in companies defaulting on debt due to even higher borrowing costs. Theexpanding of imports was also a factor in the crisis especially since the expansion in imports camewith a decline in the selling of exports in 1996 as China emerged as a major exporting nation in theregion (Wong, 1999, p. 392). Following a period of export led growth, the nations of SoutheastAsia had been investing in foreign goods at unprecedented rates causing their current accountdeficits to increase which made it even more difficult for them to maintain their currencies againstthe U.S. dollar as they lacked the currency reserves to intervene to keep the market from raising orlowering the rates (Wong, 1999, p. 392 and Van den Berg, 2004 p. 473, See Figure 3, Appendix A).Moreover, all of the borrowing in dollars and importing of goods created an extensive supply ofSoutheast Asian currencies in the hands of foreigners which was extremely problematic as thecurrencies began to fall against the dollar and demand for anything but Southeast Asian currencyincreased (Van den Berg, 2004, p. 473). The damage to the Asian economies caused by this financial tsunami was devastating.Property and goods were devalued and left unsold due to over supply, prices plunged,unemployment increased, debt grew and local currencies depreciated relative to the dollar whileinflation increased (Shapiro, 2005, p. 16, See Figure 4, Appendix A). Some countries in an effort tomaintain the dollar peg exhausted or nearly exhausted their foreign exchange reserves (Wong, 1999,p. 395). Moreover, investors from other countries pulled out of deals and as a result the stockmarkets of the affected countries crashed. This all led to a significant drop in economic growthmeasured by GDP in the years following the crisis (See Figure 5, Appendix A). Specifically, by1998 GDP fell 11 percent in Thailand, 8 percent in Malaysia and 13 percent in Indonesia (Van denBerg, 2004, p. 473). Moreover, the crises resulted in political turmoil in some countries such asIndonesia As for the rest of the world, the Asian Currency Crisis led to downward pressures hittingother foreign currencies such as the Brazilian real (World Bank, 1998). Asias problems had aneffect on markets in Russia, Latin America, Europe, and the United States (World Bank, 1998). Infact, the US economy was greatly affected by the crisis as was demonstrated by the roughly 7%drop in the Dow Jones industrial in October of 1997 and the fact that the New York Stock Exchangeeven suspended trading for a short time which in turn resulted in a decrease in consumer spending 3
  4. 4. Megan CrookhamMay 17, 2007IA 216Professor Dube(Nanto, 1998). Even Japan, the strongest economy in Asia at the time of the crisis, and the largestholder of currency reserves experienced a slow in economic growth following the crisis and Russiaunderwent a financial crisis in 1998 that likely would not have occurred had it not been for theAsian Crisis which reduced the price of oil and made international investors even more reluctant tolend to developing nations (World Bank, 1998). The only country that seemed to really benefitfrom the crisis was China which was able to make economic gains due to the losses of other Asiannations though it did temporarily experience a decrease in economic growth (Wong, 1999 andWorld Bank, 1998). Some Southeast Asian nations have still not fully recovered from the effects of the currencycrisis though conditions have improved. The crisis was resolved for the most part through actiontaken on behalf of the IMF, which provided emergency loans to countries such as South Korea,Indonesia, Thailand and Malaysia so that they would not default on all of their internationalfinancial obligations (Nanto, 1998). Specifically, the IMF put together a 37 billion dollar rescuepackage for Indonesia, a 17.2 billion dollar package for Thailand and a 55 billion dollar package ofloans for South Korea (Hill, 2006, p. 365). In return for the loans each of the nations had to adoptcertain practices which the IMF believed would foster a return to economic growth. The IMF askedthat the affected nations cut public spending, raise taxes, raise interest rates, deregulate certainsectors to allow competition, privatize state owned assets and improve financial reporting overall(Hill, 2006, p. 365). Unfortunatley, in several nations all these requirements did was worsen theeconomy by causing an increase in unemployment and further recession so really those nations thatreceived aid from the IMF are the ones who continued to suffer in the aftermath of the crisis (Hill,2006 p. 366). The IMF as a result has come under much criticism for the effectiveness of itspolicies. The IMF and its supporters consider its efforts in the Asian Currency Crises a successbecause with out the intervention of the IMF, they believe the crises would have continued to spreadand the after effects would have been much worse (Fischer, 1998). Nevertheless, the IMF isreviewing its policies should it need to step in to curb another economic crisis which isunfortunately a very real possibility. Even after the lessons of the Asian Currency Crisis there still remains the chance thatanother crisis could occur. This is due to the fact that despite the many warnings and past economiccrisis, some nations continue to carry out reckless economic policies. What is even more frightening 4
  5. 5. Megan CrookhamMay 17, 2007IA 216Professor Dubeis the fact that such an economic crisis could happen to even to the world’s largest economicsuperpower, the United States (Bergsten, 2007). The pattern of economic growth the United Stateshas experienced of late is eerily similar to that of the Southeast Asian nations. The U.S. had aperiod of export led growth through which it generated a high level of income that could be used forinternational investment. Resultantly, the United States began importing most of its goods as thespread of globalization or the increased opening of markets has increased market competitionmaking it cheaper for the United States to import rather than to produce and export goods (Shapiro,2005, p. 475, See Figure 6, Appendix A). Due to this increase in international investment which issending U.S. dollars abroad, the U.S. currently has a current account deficit of nearly 800 billiondollars which is the largest current account deficit it has ever had (Bergsten, 2007, See Figure 7,Appendix A). This means that there are more dollars in the hands of foreigners than ever before.As long as the US keeps buying foreign goods and those foreigners invest dollars in the UnitedStates everything will be fine, but should they stop investing the dollars back in the US, that iswhere the problems will arise (Ghosh and Ramakrishnan, 2006). For instance, should someone speculate the downfall of the dollar or should one nation suchas China suddenly want to sell all of their dollars, or stop investing in the United States the supplyof the dollar would be so large that demand for the dollar will fall and the demand for othercurrencies will rise therefore resulting in a devaluation of the dollar in relation to another foreigncurrency or currencies. A devaluation of the dollar to due over supply could be devastating to theUS economy and could throw the United States into a currency crisis or at least in to a recession(Bergsten, 2007). Ironically, nations such as Japan and China are now less vulnerable to a currencycrisis because they both have a current account surplus and have taken steps to build up theirforeign currency reserves following the lessons of the past (Ghosh and Ramakrishnan, 2006.) Otherthan the United States, any nation which holds a current account deficit, pegs its currency to another(making it susceptible to exchange rate risk), lacks foreign reserves, borrows too much money overthe short term, or makes a large number of investments with an inaccurate forecast of future demandand supply logistics, is vulnerable to a currency crisis. (Hill, 2006). The United States and othernations with any of these characteristics would be wise to remedy them as soon as it is fiscallypossible. 5
  6. 6. Megan CrookhamMay 17, 2007IA 216Professor Dube References 1. Bergsten, C. Fred. (2007). the Current Account Deficit and the US Economy. Peterson Institute for International Economics. ResearchID=705 . (Accessed May 14, 2007). 2. Fischer, Stanley. (1998). The Asian Crisis: A View From the IMF. (Accessed May 14, 2007). 3. Ghosh, A. and U. Ramakrishnan. (2006). Do Current Account Deficits Matter? Finance and Development, IMF, Vol. 43, No. 4: pp. 44-51. 4. Hill, Charles. (2006). Global Business Today (4th Ed.). New York: McGraw-Hill. 361-67. 5. Nanto, Dick K. (1998). The 1997-1998 Asian Financial Crisis. CRS Report for Congress. . (Accessed May 14, 2007). 6. Shapiro, Alan C. (2005). Foundations of Multinational Financial Management (5th Ed.). New Jersey: John Wiley & Sons, Inc. 7. Van den Berg, Hendrik. (2004). International Economics. New York: McGraw-Hill. 8. Wong, Y.C.R. (1999). Lessons from the Asian Financial Crisis. The Cato Journal, Vol.18, No.3: pp. 1-8. 9. World Bank. (1998). What Effect Will East Asia’s Crisis Have On Developing Countries? .(Accessed May 14, 2007). 6
  7. 7. Megan CrookhamMay 17, 2007IA 216Professor Dube APPENDIX A 7
  8. 8. Megan CrookhamMay 17, 2007IA 216Professor Dube Figure 1 Source: National Graduate Institute for Policy Studies. 8
  9. 9. Megan CrookhamMay 17, 2007IA 216Professor Dube Baht to U.S. Dollar Exchange Rate 1995-2001 Figure 2 Source: Federal Reserve Bank of St. Louis. (2004). Figure 3 Source: International Monetary Fund 9
  10. 10. Megan CrookhamMay 17, 2007IA 216Professor Dube Figure 4 Source: National Graduate Institute for Policy Studies. 5Source: Park, Yung Chul and Lee Jong-Wha. (2002). “Financial Crisis and Recovery: Patterns ofAdjustment in East Asia 1996-1999.” Asian Development Bank Institute. Research Paper No: 45 . (Accessed May 14, 2007). 10
  11. 11. Megan CrookhamMay 17, 2007IA 216Professor DubeFigure 6Source: Federal Reserve, Bureau of Economic Analysis.Figure 7Source: U.S. Bureau of Economic Analysis 11