International Finance The Asian Currency Crisis: A Case Study
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Briefly explain the origins of the Asian currency crisis.
The Asian currency crisis begun in Thailand during the second h alf of 1997. During that period, numerous banks, builders and manufactures declared ba nkruptcy due to massive debts which they were unable to re-finance nor repay. Many East Asian countries’ economic were heavily affected by the crisis. According to analysis, there are four primary factors trigger to the Asian financial crisis. The first main reason for currency and stock market breakdown was massive reversal of foreign capital flows. The net private inflows fell from US$93 billion to US$12 billion. (ILO, 1998). The second major reason is financial panic. It refers to the arbitrary shifts in the market expectation and confidence. The panic of investors aggravates the crisis as they realize these countries’ performance are weak. Additionally, the International Monetary Fund
made an erroneous decision which stops economic aid to these countries (Abdur, 1999). The third reason is the fundamental imbalances which lead to the crisis. At the start of the financial crisis in 1997, asset price, economic activity and the rapid declined of exchange rates are lead to market overreaction and herding (Giancarlo, 1998). The last reason of crisis is the financialsector weakness. There was a credit boom in 1990s in which increased credits are given to private sectors by banks and other financial institutions hence the real GDP cannot catch up with the speed of credit growth. In short term, the total bank loan dramatically increased in East Asian countries.
Expound on the roles which expectations played in the Asian currency crisis.
Expectations played a central role that caused the bubble in East Asian financial systems. Griffith-Jones (1998) stated that the actions of international investors are largely influenced by other investors’ expectations rather than consideration of economic background. Therefor e, although Asia economic fundamentals were in good conditions, foreign investors’ views were
still sensitive and negative to the market. Specifically, the implicit guarantees of Asian governments deceived investors into investing in risky projects with expectation of loss covered by governments. However, this guarantee paved the way for the oversupply of real estates and made the economies excessed their production capacities which resulted in large amounts of bad debts and defaults (Felmingham & Short, 2003). These situations gradually exacerbated and when investors realized the incapability of government to secure the risks due to the lack of resources, asset values sharply declined, causing the bubble burst. This decline then further worsened loan defaults, leading to the collapse in confidence which was the base of Asian economies. In turn, this triggered a huge wave of withdrawals of fund as foreign investors refused to renew loans and
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began to sell off their invested assets (Radelet & Sachs, 2000). This ended up with the fall of local currencies, then the increase the cost of foreign debts. Moreover, this process was a contagious phenomenon which spread out to other countries in the area with similar characteristics (Griffith-Jones & Pfaffenzeller, 1998). In this case, it can be seen that the crisis started in Thailand and then extended to other countries such as Malaysia, Indonesia and Korea with the similar process of bubble burst. In addition, because of the currency crisis, Asian central banks were inclined to devalue their currencies to recover the export competitiveness (Huh & Kasa, 1998). Consequently, these incentives opened up profitable opportunities for investors and speculators to attack the East Asian currencies.
Illuminate on how the appreciation of the U.S. dollar and depreciation of the yuan affect the timing and degree of the Asian currency crisis.
The Asian currency crisis in 1997 was a result of a robust economic growth period without strong financial systems and lacking of management for risk exposures. Therefore, the appreciation of the US dollar and the yuan depreciation were factors that escalated the process of this crisis. Firstly, the export competitiveness of most Southeast Asia countries were severely damaged by the sharp appreciation of US dollar since the first half of 1995. This is due to the fact that Asian nations such as Thailand and Malaysia were pursuing the economic growth by exporting and the most important market at that time was the US (Radelet & Sachs, 2000). As a result, these export-depended economies’ currencies were pegged to the US dollar. Hence, the dollar appreciation means that their currencies were also appreciated, leading to the relative increase of export products or the decrease of export competitiveness (Glick, 1999). This loss then led to an idle of production capacity and damaged the return on investments in these countries. Furthermore, Radelet and Sachs (2000) also noted that a s the foreign debts of most Asia countries were dollar-denominated, their real debt serving burden was moderately raised due to the dollar appreciation. Consequently, these chain reactions resulted in the deterioration in current account deficit and triggered the action of currency devaluation of central banks (Huh & Kasa, 1998). This created opportunities for speculators to strike on the Asian currencies which worsened the crisis. Another factor is depreciation of yuan which also significantly impacted the Asian currency crisis. For other Asian nations, China is clearly the main competitor who exported similar products to the same key markets such as the US (Glick, 1999). The depreciation of yuan brought about the increase of Chinese export competitiveness as their products became
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cheaper than those of other Asian countries. Similar to the dollar appreciation, this phenomenon also sped up the currencies crisis in Asia.
Explain on what moral hazard is and how it contributes to the Asian currency crisis.
Moral hazard occurs in the circumstances of a party delving in risky behaviours with knowledge and awareness that one is safeguarded from the risk whilst another party will be exposed to the uncertainties (The Economic Times, 2016). The decision is grounded not on what is measured to be ethical, but what delivers the highest level of return, thus the association with morality (Investopedia, 2003). According to Chang (2000), there are various events which attributes to moral hazard such as industrial policy and cronyism. Industrial policy was mainly popularised by the Korean government and chaebols (large family owned enterprises) by poorly investing in projects and industries which are deemed to be economically strategic however, it was unrealistic as majority of the investments did not provide the same value of return (Chang, 2006). On the onset, the policy blurred loan decisionmaking as the financial institutions did not foresee a bubble burst, having full confidence in notion of the government implicit guarantees. Next, cronyism is known as lending decisions based on powerful personal connection as well as politically interest based. Billions of dollars are easily loaned out to corporations with ties to the well-connected, which resulted in massive over lending. Poor corporate governance as above together with loans provided by the bank loosely without adhering to proper bank regulations resulted in an overinvestment which are financed by enormous quantities of debt and inflated prices of assets in short supply of properties, such as real estate and land (Sato, Ramachandran and Mino, 1999). Large amount of non-performing loans and widespread credit defaults due to moral hazards convinced the foreign investors of the structural instability. They withdrew their investments by refusing to renew or extend loans and begin to sell off shares of overvalued companies which exacerbated capital flight followed by the fall of native currencies which increases the costs of servicing foreign debts which further intensifies the Asian currency crisis.
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What were the risks that many East Asian companies and banks exposing themselves to when they borrow dollars, yen and Deutsche marks and why did they do so to finance their operations?
Foreign currency such as US Dollars, Japanese Yen and Deutsche Marks were borrowed by East Asian countries to finance their operations- borrowing a total of $275 billion. East Asian countries were export dependent and the competitiveness of exports was determined by the exchange rate of its major importers and competitors. Many East Asian countries had pegged its currency against the dollar such as Thailand, which had pegged the Baht to 25BHT/US$ (Fratzscher et al. 2000, pg. 12) to maintain export competitiveness. Foreign currencies’
financial stability and comparatively lower interest rate s meant it was financially sound for East Asian countries to fund their operations with foreign currency rathe r than domestic currency. This dependency on maintaining a fixed exchange rate exposed East Asian currencies to domestic currency market attacks as well as the need for central banks to keep a large and diversified reserve to continually ease or tighten their stance in the money market. The constant need to have deep reserves resulted in East Asian currencies exposing themselves to risk of not having an adequate reserve to continually pegged their currency. Sub-prime loans were issued to investors’ in East Asian, financed by debt and inflated asset prices with the government acting as the lender of last resort (Corsetti, Pesenti & Roubini, 1999). This credit bubble coupled with speculative attacks on local currency where investors would sell short to profit from a future decline of the rate of exchange against the dollar, lead to major devaluation in East Asian currencies. The Malaysian Ringgit was devalued more t han 30% (Fratzscher et al. 2000, pg. 12) which had major effects on the value of exports and economic growth; governments also lacked the funds to maintain the pegged currency during these speculative attacks. Without adequate reserve levels, governments were unable to bail out investors causing a contagion effect which lead to a collapse of the market. This inability to pegged their currency to the dollar lead to the depreciation of local currency, causing a rise in the cost debt and a reduction in the balance of trade (Wang, 2000). There was a spiral on effect that impacted East Asian economies as depreciation lead t o lower export prices causing a loss of profits which deteriorated East Asia n’s chance of repaying their current account deficits.
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References
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Chang, S., 2006. Business groups in east Asia. Oxford: Oxford University Press, p.8. Corsetti, G., Pesenti, P. and Roubini, N., 1999. What caused the Asian currency and financial crisis?. Japan and the world economy , 11(3), pp.305-373. Felmingham, B. and Short, L., 2003. An Anatomy of Currency Crises. Journal of Economic Integration, pp. 587-606.
Fratzscher, M., Agénor, P.R., Miller, M., Vines, D. and Weber, A., 2000. The Asian Financial Crisis. Causes, Contagion and Consequences. Giancarlo.,1998, ‘What caused the Asian currency and financial crisis?’ NBER working paper NO.6833 Glick, R., 1999, ‘Thoughts on the origins of the Asian crisis: impulses and propagation mechanisms’, in The Asian Financial Crisis: Origins, Implications, and Solutions, Springer US,
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Radelet, S. and Sachs, J., 2000, ‘The onset of the East Asian financial crisis’, in Currency crises, University of Chicago Press, pp. 105-153.
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