Govt Intervention During Asian Crisis


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Solution of Chapter end Case from the book International Finance by Jeff Madura, chapter-6

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  • East Asia was a booming part of the world. With high rates of saving and investment; rapidly improving educational levels among the work force; and if not free trade, at least a high degree of openness to and integration with world markets. Capital Market liberalizations 1900s, increased financial transactions through the banks. Shift from an inward-looking, import-substitution development strategy to one that emphasized exports. During the 1990s: massive capital inflows were accumulated progressively along with a high interest rate differential and under fixed exchange rate regime, including capital account deregulation
  • Although the capital markets were liberalized, the financial sector was poorly managed and underdeveloped. The circumstances worsened through short-term borrowing abroad, primarily to finance long-term projects, leading to currency and maturity mismatches. As a result, a balance-sheet crisis occurred due to sudden capital outflows. The foreign short-term liabilities had exceeded international reserves in 1996. As soon as the baht was floated, foreign debt in local currency overshot, the sovereign rate of Thailand decreased, and then investors’ sentiments were adversely affected. The banks held many short-term liabilities denominated in foreign currencies, and the sharp increase in the value of the liabilities after the devaluation led to a further deterioration in the banks’ balance sheet. In all this, the IMF stepped in and the countries were able to prevent a bank panic by the cushion in aid provided that protected depositors. In all the ability of the bank to lend was sharply reduced. The cost of the bailout for the banking system was more than 15% of GDP in these countries and more than 50% of GDP in Indonesia, about 13% in Philippines. Liquidity crunch from capital flight
  • Thailand: real estate bubble burst, then the stock market tumbled. It began with a currency crisis even though the nations had weaknesses that only worsened the crisis. George Soros bets on the baht- speculation about a devaluation let to an accelerating loss of foreign reserves. This leads to the speculation against neighboring country currencies- Malaysia, Indonesia and Korea. Crisis worsened by the economic slump in Japan. The economies were highly dependent on trade, partly from the fact that domestic banks and companies had large debts denominated in dollars. Faced with the dilemma that allowing their currencies to drop would raise import prices, leading to inflation As a counterpart to the large capital inflows several of the Asian countries began running large current account deficits
  • South Korea was the world’s 8 th largest economy, and one of the strongest. But as it had failed to deal with its banking problems, and the market knew that its banks were wea
  • January 12: Asia’s largest private investment bank, the Hong Kong- based Peregrine Investments, files for liquidation. The company is left badly exposed from its loan in investments in Indonesia. June: Japan and the US spend some $6 billion to buy yen in order to strengthen it. IMF’s efforts of advice on tighter fiscal and monetary policies were intended to stem the capital outflow but actually caused bankruptcies and killed the growth that was essential for private sector recovery.
  • Drop in currencies make exports attractive but imports more expensive. The east Asian countries were highly dependent on trade. Also domestic banks and companies had large debts denominated in dollars. So a drop in the domestic currency means foreign currency becomes more expensive, relatively increasing the value of the dollar denominated debts even though the debts are the same. The huge influx of foreign capital happened with the market liberalization. The differential in interest rates played in favor of the domestic market and investor began to spend more and more in these economies.
  • lack of supervision by bank regulators and lack of expertise in screening and monitoring borrowers at banking institutions, losses on the loans began to mount ( An estimated 15% to 35% of all bank loans turned sour in Thailand, Indonesia, Malaysia, and south Korea), causing an erosion of bank’s net worth (capital). As a result of this erosion, banks had fewer resources to lend and this lack of lending eventually led to a contraction in economic activity. Corruption..close ties between business interests and government officials appear to have helped foster considerable moral hazard in lending. All wanted financial liberalization but lacked proper government supervision. Heavy reliance on banks due to underdeveloped capital markets Pegged exchange rate made the adjustment process more difficult
  • Govt Intervention During Asian Crisis

    1. 1. Welcome to Our Presentation
    2. 2. Group-1  Name Sunanda Sarker Md. Foysal Ahmed A.S.M. Misbaul Islam Md. Ataur Rahman A. B. M. Kalim Ullah Ahsanul Karim  Roll No. 161201 161204 161220 161221 161245 161251
    3. 3. Agenda..  Crisis in Thailand  Crisis timeline  The dilemma  Asian Weaknesses  Impact of Asian Crisis on different countries  Case Questions
    4. 4. Countries involved..  Thailand  Singapore  Philippine  Taiwan  Indonesia  Hong Kong  Russia  South Korea  China  Japan  Latin America  Europe
    5. 5. Thailand Case  May 1997: Thailand spends billions of its foreign reserves to defend the Thai baht against speculative attacks  In case of Thailand:  Allowing too many short-term capital flows to accumulate with a high degree of currency speculation,  Outflow of funds expedited the weakening of the bath, as foreign investors exchanged theirbaht fortheirhome currencies,  Sustaining a fixed exchange rate when it was no longersuitable,  Lack of sufficient risk management system at the national level as well as regional level in case of bank lending (defaulted loan piled up over $30 billion),  Products were not priced as competitively to US importers,  Concerns of large current account deficits,  Weakness in the Thai financial system, Thai govt.’s heavy borrowing made the debt expensive to public.  Speculative attacks brings down investor confidence causing- “capital flight”
    6. 6. Crisis Timeline..  July 1997 Thailand is forced to devalue the baht, which drops the value of the baht by as much as 20%-- a record (had actually attempted a 15% controlled devaluation) Malaysia’s central bank intervenes to defend the ringgit. The Philippine peso is devalued. Indonesia widens its trading band forthe rupiah in a move to discourage speculators The Singapore dollar starts a gradual decline.
    7. 7. Crisis timeline..Contd/.  August1997 Thailand agrees to adopt tough economic measures proposed by the IMF in return for a $17 billion loan from the international lender and Asian nations. The Thai government closes 42 ailing finance companies and imposes tax hikes as part of the IMF's insistence on austerity Indonesia abandons the rupiah's trading band and allows the currency to float freely, triggering a plunge in the currency
    8. 8. Crisis timeline..Contd/.  October1997 Indonesia asks the IMFand World Bank forhelp after the rupiah falls more than 30% in two months, despite interventions by the country's central bank to prop up the currency Hong Kong's stock index falls 10.4% afterit raises bank lending rates to 300% to fend off speculative attacks on the Hong Kong dollar. The plunge on the Hong Kong Stock Exchange wipes $29.3 billion off the value of stock shares. The South Korean won begins to weaken The IMFagrees to a loan package forIndonesia that eventually swells to $40 billion. In return, the government closes 16 financially insolvent banks and
    9. 9. Crisis timeline..Contd/.  November1997 Bank of Korea allows the won to fall below 1000 against the dollar(record low)  December1997 IMF approves a $57 billion bailout package to the South Korea As part of IMF economic restructuring plan, the Thai government closes 56 insolvent finance companies (30,000 white collarjobs lost) South Korea’s first president elected from country’s opposition party. In days the won hits new low. $3 billion emergency loan released by the world bank ,
    10. 10. Crisis timeline..Contd/.  January 1998: Release of Indonesia budget plan pulls the rupiah to an all- time low Inflation rises. Prices for basic food staples in Indonesia increase by as much as 80% The rupiah plunges to 12,000 rupiah against the dollar  June 1998 Japan announces that its economy is in a recession Yen falls to levels near 144 to the dollar. US treaury and Federal reserve intervenes to prop up the yen  August 1998 Wall Street reacts; the Dow plunges 300 points in its third biggest loss
    11. 11. How Exchange rates changed during Asian Crisis (June1997- June 1998)
    12. 12. How Interest rates changed during the Asian Crisis (Annualized interest rates as of June 1997 and of June 1998 are represented by Number before slash and Number after slash respectively)
    13. 13. Dilemma..  Drop in currencies Raise import prices leading to inflation threat Threat that potentially viable banks and companies may become bankrupt  Defend the currency  would mean to raise interest rates Threat of economic slump resulting in the failure of banks
    14. 14. Asian Weaknesses..  Weaknessesthat becameapparent after thecrisis: 1. Productivity: economic expansion beforecrisis later explained by therapid growth of production inputs(capital and labor) – but relatively little increasein productivity 2. Banking Regulation: Ineffectivegovernment supervision 3. Exchange rate regimes- Mostly pegged exchange ratesystem 4. Legal Framework: lack of structured legal framework to deal with bankruptcy
    15. 15. Impact of Asian Crisis All Over the World .. Currency value declined Interest rate increased Demand and national income reduced Bad loans piled up Cost of borrowing increased Stock prices reduced in Hong Kong Large firms in Japan announced shut down Export oriented countries rely on Asian products heavily affected by this crisis Bond rating as well as bond price reduced in Latin America
    16. 16. Case Questions.. 1. Was the depreciation of the Asian currencies during the Asian crisis due to trade flows or capital flows? Why do think the degree of movement over a short period may depend on whether the reason is trade flows or capital flows? 2. Why do you think the Indonesia rupiah was more exposed to an abrupt decline in value than the Japanese yen during the Asian crisis (even if their economies experienced the same degree of weakness)? 3. During the Asian crisis, direct intervention did not prevent depreciation of currencies. Offer your explanation for why the interventions did not work.
    17. 17. 4. During the Asian crisis, some of the local firms in Asia borrowed dollars rather than local currency to support local operations. Why would they borrow dollars when they really needed their local currency to support operations? Why did this strategy backfire? 5. The Asian crisis showed that a currency crisis could affect interest rates. Why did the crisis put upward pressure on interest rates in Asian countries? Why did it put downward pressure on U.S. interest rates? 6. It is commonly argued that high interest rates reflect the expectation of high inflation. Based on this theory, how would expectations of Asian exchange rates change after interest rates in Asia increased? Why? Is the underlying reason logical? Case Questions..
    18. 18. 7. During the Asian crisis, why did the discount of the forward rate of Asian currencies change? Do you think it increased or decreased? Why? 8. During the Hong Kong crisis, the Hong Kong stock market declined substantially over a four-day period due to concerns in the foreign exchange market. Why would stock prices decline due to concerns in the foreign exchange market? Why would some countries be more susceptible to this type of situation than others? 9. On August 26, 1998, the day that Russia decided to let the ruble float freely, the ruble declined by about 50 percent. N the following day, called bloody Thursday, stock markets around the world (including the U.S.) declined by more than 4 percent. Why do you think the decline in the ruble had such a global impact on stock prices? Was the market’s reaction rational? Would the effect have been different if the ruble’s plunge had occurred in an earlier time period, such as four years earlier? Case Questions..
    19. 19. 10. Normally, a weak local currency is expected to stimulate the local economy. Yet, it appeared that the weak currencies of Asia adversely affected their economies. Why do you think the weakening of the currencies did not initially improve the economies during the Asian crisis? 11. During the Asian crisis, Hong Kong and China successfully intervened (by raising their interest rates) to protect their local currencies from depreciating. Nevertheless, these countries were also adversely affected by the Asian crisis. Why do you think the actions to protect the values of their currencies affected these countries’ economies. Why do you think the weakness of other Asian currencies against the dollar and the stability of the Chinese and Hong Kong currencies against the dollar adversely affected their economies? Case Questions..
    20. 20. 12. Why do you think the values of bonds issued by Asian governments declined during the Asian crisis? Why do you think the values of Latin American bonds declined in response to the Asian crisis? 13. Why do you think the depreciation of the Asian currencies adversely affected U.S. firms? (There are at least three reasons, each related to a different type of exposure of some U.S. firms to exchange rate risk.) 14. During the Asian crisis, the currencies of many Asian countries declined even though their governments attempted to intervene with direct intervention or by raising interest rates. Given that the abrupt depreciation of the currencies was attributed to an abrupt outflow of funds in the financial markets, what alternative Asian government action might have been more successful in preventing a substantial decline in the currencies’ values? Are there any possible adverse effects of your proposed solution? Case Questions..
    21. 21. Questions?????...