Outline1. Definition of Currency Crisis2. Theoretical Models of Currency Crises and their Applicability to Malaysia.3. Asian Economic Outlook before the crisis Outline4. Causes of the Currency Crisis5. Response to the Crisis6. Lessons from Malaysian Currency Crisis7. Malaysian Economic Outlook after the crisis8. Conclusions
Definition of Financial CrisisCurrency crisis: Defined as a situation in which an attack on the currency leads to substantial reserves losses, or to a sharp depreciation of the currency – if the speculative attack is ultimately successful – or to both.Banking crisis: – Performance of bank stocks relative to the overall equity market – Non-performing loans – Bank runs " closure, merging or takeover by public sector
Brief History of Crisis Malaysian Currency Crisis 1997/98 “I can‘t imagine that 20 or 25 years ago my predecessors would have been worried about an economic crisis in Thailand or Indonesia, or even Korea” Robert Rubin, Former Secretary of the Treasury Much more heterogeneous than first two generations Three main variants: – Moral-hazard-driven lending – Currency crises as the byproduct of a bank run – Balance-sheet implications of currency depreciation Short-term debt Other key topics: Maturity mismatch, currency mismatch, contagion, crony capitalism, etc.
Economic Outlook before Crisis Graphs taken from: WORLD ECONOMIC OUTLOOK Interim Assessment December 1997 A Survey by the Staff of the International Monetary Fund
Causes Broadly, the views about Malaysian financial crisis can be divided into two categories: Macroeconomic imbalances and structural distortions. Sudden shifts in market expectations and confidence.
Causes (Continued) Current account deficits and composition of foreign liabilities. Fixed exchange rates system and overvalued currencies. Failure of developmental state model. Unfavorable changes in external environment. Inadequate financial supervision and regulation. Moral hazard. Inherent flaws of global financial structure.
Current Account Deficits and Compositionof Foreign Liabilities It has been widely agreed that a current account deficit should be closely monitored if it is in excess of 5% of GDP and largely financed in a way that could lead to rapid reversals. Large current account deficits mostly financed by short-term reversible investments.
Fixed Exchange Rates System andOvervalued Currencies Almost all these economies pursued export led growth by keeping the currency fixed with USD. When USD appreciated in 1995, the real exchange rates appreciated and deteriorated the cost competitiveness. Problems arose when the central banks were unable to support the currency against currency speculation in view of their small international reserves.
Failure of Developmental State Model Most of these Asian countries followed Japanese growth model with all its inefficiencies like speculative investment, crony capitalism and unsound business and economic decisions. These decisions led to bad loans, unsustainable growth and overvalued assets.
Unfavorable Changes in ExternalEnvironment Changes in international financial system like capital account liberalization and financial market deregulation played a critical role. Some aspects like intense competition from China, Japan’s economic slow down and a worldwide fall in demand of semi conductors also significantly affected the exports from Malaysia.
Inadequate Financial Supervision andRegulation Market liberalization was not accompanied by sophisticated control systems and the supervisory capacity was limited. As a result of negligent supervision there were low capital adequacy ratios, lack of deposit insurance schemes and risky lending.
Moral HazardKrugman pointed out two dimensions of Moral Hazard: Domestic banks were seldom concerned about their investment and were anticipating a bail out by Government. International investors also anticipated a bail out either by governments or IMF.
Inherent Flaws of Global FinancialStructure According to this view roots of capital flows lie in the Global Financial structure in which there are repeated patterns of “Booms” and “Busts” Increasing confidence leads to massive capital inflows followed by busts created by panic by investors.
IMF Conditionality Tighten Macroeconomic Policies: ↓ Government deficit: ↑ T , ↓G ↓ Current account deficit: 2% Tight monetary policy ↑interest rate Financial Sector Reform: Enhance regulations and supervisions ↑Transparency/Disclosure Closure of troubled financial institutions Real Sector Reform:
Measures Taken By GovernmentOnly Three Measures Taken by Govt.1- Freezing the External Ringgit Account2- Fixing the Exchange Rate @3.80RM/$3- Introduction of Twelve Month Rule Source: The Malaysian Currency Crisis Mahatire Bin Muhammad (1997)
Lessons: Malaysian Currency Crisis Key Lessons: Financial market reform Manage investor confidence Curb unproductive & speculative capital Accumulate huge international reserve Avoid excessive reliance on external fund & short-term capital Reform international financial architecture Embrace flexible exchange mechanism Temporary currency & capital control
Lessons: Financial Market Reform Develop robust & resilient financial system. Strong institutions with capabilities & expertise Disclosure & accounting reform (i.e. International Accounting Standards) Adopt proven & stricter regulations - International organizations (i.e. IMF, World Bank, Asian Development Bank) - Developed financial centers (i.e. New York, London)
Lessons: Manage Investor Confidence Continuously improvement in investment climate by enhancing regulations, intensifying supervision, tackling corruption etcCaprio (1998) Ranking Country Ranking Country 1 Singapore 7 Malaysia 2 Argentina 8 Colombia 3 Hong Kong 9 South Korea 4 Chile 10 The Philippines 5 Brazil 11 Thailand 6 Peru 12 IndonesiaSource: “Asian Crisis: Distilling Critical Lessons”, Dilip K. Das
Lessons: Curb Unproductive & Speculative Capital Avoid or cut speculative activities in real properties & securities In Thailand 70% of foreign capital is invested in securities
Lessons: Accumulate Huge International Reserve Feldstein (1999) supports this notion in view of increasing integration of world capital market. Singapore’s Experience ($194 billion or > 8 months import as at end of February 2006). Foreign Reserves (in months of imports) 1993 1994 1995 1996 1997 Korea 2.53 2.63 2.52 2.32 1.42 Indonesia 3.60 3.24 2.94 3.64 3.26 Malaysia 5.64 4.53 3.29 3.59 2.73 Philippines 2.59 2.81 2.33 2.95 1.79 Thailand 5.64 5.65 5.35 5.53 4.40 Hong Kong 3.33 3.27 3.10 3.47 4.80 Taiwan 10.64 10.90 8.90 8.68 7.56
Lessons: Avoid Excessive Reliance onExternal Fund & Short-term Capital Large capital inflows can potentially have a destabilizing impact over the recipient economy, particularly when the currency is convertible. Short-term capital inflows are known to cause volatility in financial markets, which leads to macroeconomic instability. Monetary authorities should keep strict watch over short-term borrowings denominated in foreign currencies.
Lessons: Reform International Financial Architecture Gordon Brown, former British Chancellor “… focuses on the stability and integrity of the world financial system should be directed on code of conduct; monetary policy, fiscal policy ...” BBC February 21, 1998 Total assets of top international financial/hedge funds are higher than reserves of some countriesTop International Fi nancial/ He dge Funds 2004 Key Economic Indicators Reserves of 2004 External Company Foreign Exch. Assets Debts & Gol d Soros Fund Management $13.0 b Indonesia $141.5 b $35.8 b Bridge water Associates $12.4 b Mal aysia $53.4 b $55.3 b D.E. Shaw $11.4 b Philippi nes $55.6 b $16.1 b Gol de n Sachs Assets Management $11.2 b Singapore $19.4 b $112.8 b Farallon Capital Management $12.5 b S. Korea $160.0 b $199.1 b Caxton Associate $11.9 b Thailand $50.6 b $48.3 bSource: Absolute Return Magazine (Top International Financial/Hedge Funds)
Lessons: Embrace Flexible Exchange Mechanism Prior to crisis, monetary framework in most Asian countries was anchored to the fixed exchange regime. Pegging is infeasible as international reserves and financing were insufficient for developing countries. Fixed exchange rate vulnerable to speculators’ attack.
Lessons: Temporary Currency & Capital Control• Malaysia experience: - Imposed currency & capital controls September 1,1998 - Reverting to floating exchange a day after China on July 22, 2005 - Supported by Prof. Bhagwati - Refuted claims by many economists that Malaysian economy not sustainable GDP Growth (%) 1997: 7.3% 1998: -0.1% 1999: 5.8% 2000: 8.5% Source: “Capital & Control: Lesson from Malaysia”, Rawi Abdelal & Laura Alfaro (2003)
Lessons: Temporary Currency & Capital Control2004 Key Economic Indicators GDP Purchasing power parity Real Growth Rate Per capital Indonesia (Aid from IMF) $827 b 4.9% $ 3,500 Mal aysia $229 b 7.1% $ 9,700 Philippi nes $431 b 5.9% $ 5,000 Singapore $121 b 8.1% $ 27,800 S. Kore a (Aid from IMF) $925 b 4.6% $ 19,200 Thailand (Aid fro m IMF) $525 b 6.1% $ 8,000 Reserves of Foreign Exc hange & Gol d Indonesia $ 35.8 b Mal aysia $ 55.3 b Philippi nes $ 16.1 b Singapore $ 112.8 b S. Kore a $ 199.1 b Thailand $ 48.3 b China $ 610 b India $ 120 bSource: “World Factbook ” extracted from http://education.yahoo.com (2004 estimated data)
Conclusions The Asian financial crisis represents a new generation of crisis. It involved not only currency exchange problems but also banking problems. Macroeconomic experts were unable to predict it, since economic conditions remained generally good and private foreign capital was flowing in at a record pace and on very attractive terms.
Conclusions (Continued) Some key elements: failure to reduce overheating pressures, current account deficits funded with speculative short term debt, lack of soundness, transparency, and supervision of financial system, overvalued properties and stock markets (bubbles), excessive exposure to foreign exchange risk in both the financial and corporate sectors and lax prudential rules.
Conclusions (Continued) The failure of the IMF rescue package reinforced the importance of the soundness in macroeconomic and financial sector fundamentals. The causes of the financial crisis in Asia are complex and will need to be thoroughly analyzed both to reduce the risk of similar occurrences in the future and to identify appropriate lessons for economic policies.