East Asian currency crisis of 1997/98 Essay Example

In Indonesia, for instance, 60 percent of its population lived below the poverty line in 1960; however, only 15 percent remained below it by 1996.

The Asian-5 were vulnerable to economic collapse due to various factors leading up to the crisis. From 1990 to 1996, capital inflows, mainly through foreign borrowing by financial institutions and banks, averaged at over 6% of GDP. However, these flows could easily reverse in times of financial panic. To increase capital inflows with short maturity structures where central banks absorbed investors' risks, governments maintained stable exchange rates. The real exchange rates appreciated by approximately 25% in four South East Asian countries between 1990 and early 1997, which affected nontradeables prices like real estate prices. This led to upward pressure on export prices, reduced competitiveness and a sharp decline in export growth.

In the mid-1990s, all countries experienced a decline in export growth, except for the Philippines. Thailand even had a decrease in nominal dollar terms in exports in 1996 (Table 2). This was due to several factors, including currency overvaluation, the appreciation of the Japanese Yen against the US Dollar, a global excess of semiconductor production, and increased competition from Mexico's participation in NAFTA. Notably, bank lending expanded rapidly, reaching 140 percent of GDP in Thailand, Korea, and Malaysia in 1996. Additionally, there was a rise in short-term foreign borrowing, with Korea, Thailand, and Indonesia having short-term debts to offshore banks of $68 billion, $46 billion, and $34 billion respectively by the end of 1996 (Table 3).

After 1994, the short-term debt to reserve ratio in three countries exceeded one, which is sustainable only when lenders are willing to renew loans. However, it

indicates a susceptibility to crisis. In the event of a capital outflow, foreign creditors have an incentive to demand prompt repayment as they understand that foreign exchange reserves are insufficient. The crisis began in early 1997 in Korea and Thailand, with Hanbo Steel, a Korean conglomerate, declaring bankruptcy with debts of $6 billion. Shortly thereafter, Kia Motors and Sammi Steel also experienced similar difficulties.

Financial troubles in South Korea, including pressure on offshore borrowing for lending to chaebol, and concerns about the finances of other Korean corporations, added to the difficulties. Meanwhile in Thailand, a major property developer called Somprasong Land failed to fulfill foreign debt obligations and property prices began to drop in late 1996. As a result, confidence waned in Thai financing firms with exposure to the property markets. This led to speculative attacks on the baht in late 1996 and early 1997.

In an attempt to prevent speculation regarding the financial system's fragility and dwindling foreign exchange reserves, the government made assurances that Finance One, Thailand's prominent finance company, would be rescued, and the baht would not be floated. Regrettably, Finance One collapsed on May 23rd, and on July 2nd the baht was released, causing a significant outflow of capital from the area (as shown in Table 4). Foreign creditors presumed that other economies in Southeast Asia and Korea may also be struggling if Thailand was facing difficulties.

The flow of capital from some countries increased, resulting in intense pressure on the exchange rates of four South East Asian countries which caused a 20 percent currency devaluation. This spiral of further capital withdrawals put more pressure on exchange rates. Mistakes by the IMF

and governments of the countries led to panic and an escalated crisis. Despite prior economic performance, the severity and unpredictability of the situation surprised many. The essay investigates currency crisis models that could shed light on why East Asia experienced such extreme crises.

Krugman (1979) developed the first formal model for currency crises, which is referred to as a "first generation model". The root cause of crises, according to Krugman's theory, is an inconsistency between the economic fundamentals required to maintain a fixed exchange rate system and the domestic monetary policy. The model is based on the assumption that the government, unable to access capital markets, must monetize its expenditures. As a result, weaknesses emerge due to excessive creation of domestic credit to finance fiscal deficits or support a vulnerable banking system. Maintaining interest rate parity through capital outflows and gradual loss of foreign exchange reserves eventually leads to a speculative attack on the foreign exchange reserves when they reach a "critical level".

According to the text, speculators are likely to deplete remaining reserves quickly in order to avoid losses and trigger the abandonment or devaluation of the peg. This occurs as a result of persistent budget deficits funded via money, which hastens the depletion of foreign exchange reserves, eventually leading to a speculative attack. In "second generation" models, the government has the option to defend a pegged exchange rate, creating a balance between credibility and macroeconomic stability in the short term, without necessarily requiring a continuous deterioration of economic fundamentals. The model follows three specific conditions.

There are three conditions for a government to abandon or defend a fixed exchange rate. Firstly, there must be

a reason for the government to abandon the fixed rate such as high unemployment where expansionary monetary policy may be required. Secondly, the government may defend the fixed rate if they believe it is important for efficient trade and investment. Finally, the cost of defending the exchange rate must rise when expectations of abandonment increase.

Expectations of a future depreciation may necessitate the enforcement of elevated short-term interest rates to protect the peg. However, this course of action will result in a further reduction of output and employment. If the expenses related to maintaining parity increase, the government may consider devaluation in the future. Proactive investors may recognize this possibility and divest themselves of the currency now. Such a move would worsen the government's trade off and accelerate the likelihood of an earlier devaluation, prompting additional investors to sell. This dynamic permits the possibility of multiple equilibria; the success or failure of the attack on the peg depends on whether or not the government defends it.

The currency crises that occurred in Europe in 1992 during the ERM were caused by governments abandoning the regime to pursue expansionary monetary policies. This decision was made because they believed that maintaining parity was not as important as having macroeconomic flexibility. Although some argue that "second generation" crises cannot be predicted, they are often the result of currency speculation, creating a "self-fulfilling" crisis. Models highlight the significance of 'herding behaviour' among foreign investors, who may be more susceptible to rumors due to imperfect information (Calvo and Mendoza 1997). However, these currency crisis models do not provide a satisfactory explanation for the Asian crisis.

Prior to 1997, the absence of factors

that drive "first generation" models contributed to the Asian financial crisis. Governments had not engaged in reckless credit creation or monetary expansion and were fiscally balanced. In addition, Asian countries had low inflation rates, in contrast to South American economies where previous currency crises were often attributed to high inflation rates and excessive credit creation according to these models. Furthermore, international factors like the 1982 Mexico crisis caused by a significant increase in US interest rates were not present.

At the time of the Asian crisis, the global financial situation remained stable. "Second generation" models state that policy inconsistencies can cause governments to abandon exchange rates when faced with high unemployment and recession. The UK currency crisis in 1992 saw the government avoid maintaining parity due to concerns that raising interest rates would further contract an already struggling economy. However, the Asian 5 economies experienced growth and low unemployment rates. Krugman (1998) suggests a third approach is necessary for East Asian economies, as the preceding boom-bust cycle in asset markets and widespread financial intermediaries better explain the collapse observed in Asia.

The theory emphasizes the significance of intermediaries, particularly "Finance Companies" in Thailand, who acquired short-term loans and lent them to high-risk investors. The intermediaries encountered substantial moral hazard issues since their obligations were believed to have an implicit government assurance. Appendix 1 displays a basic numerical demonstration of this problem. The proprietor of the intermediary secured $100 million from guaranteed debtors and did not furnish any personal capital (Milgrom and Roberts 1992).

Even if the chances of a "good state" and a "bad state" are equal, a risk neutral investor would prefer the safe asset with a

return of $7million. However, if the owner of the intermediary can have no loss in the bad state and expect a gain of $10 million in the good state, they would choose the risky asset even though it has a lower expected return. Krugman uses this idea of moral hazard to argue that under-regulated financial intermediaries with excessive guarantees can result in excessive investment for the entire economy. In Krugman's model, owners of intermediaries prioritize a "Pangloss" value, or the value of an investment in the best possible scenario, rather than expected investment values.

Excessive investment can result in a lower expected welfare because increased returns in the 'good state' are overshadowed by losses in the 'bad state'. Assuming perfectly elastic supply of capital goods, all additional investment demand due to financial excess results in increased actual investment. Alternatively, assuming completely inelastic asset supply, investment distortions lead to higher land prices. In the example presented, land price is doubled (see Appendix 2). The Krugman model entails implicit guarantees until they become too costly to honour. Intermediaries' losses may lead to creditors being bailed out, causing future creditors to withdraw capital and leading to intermediary collapse.

The possibility of disintermediation can lead to significant economic losses, as the end of intermediation may cause a further decrease in asset prices and the collapse of more institutions. In Asia, changes in the financial regime have led to the closure of finance companies and banks, while others have had to limit risky lending practices. According to a model presented by Krugman in 1998, the Asian crisis may have been caused more by bad financial practices than by currency issues. The

model indicates that the Asian economies were susceptible to self-fulfilling crises, rather than currency fluctuations. This theory contradicts the "first" and "second generation" models and suggests that the financial crisis was the trigger for the collapse in Asia, with currency fluctuations serving as a symptom rather than a cause.

One of the limitations of the model is its assumption that intermediaries are just rent-seeking tools without any useful purpose and that their owners do not invest any of their own capital, both of which are unrealistic. Additionally, the model solely holds intermediaries accountable for overinvestment and overvaluation of assets.

Despite severe crises, foreign investors still invested in stocks and real estate, indicating possible market failures like 'herding behaviour'. The Krugman model alone is insufficient according to empirical evidence. This theory attributes the crisis to risky investments by intermediaries leading to a sharp deterioration in lending patterns prior to the crisis. Sector-specific lending shares of banks and financial institutions in the Asian-5 in 1990 and 1996, displayed in Table 5, indicate a modest shift from manufacturing to real estate, construction, and services. However, Indonesia experienced a significant shift while the Philippines saw a small one10.

The findings are varied, indicating a moderate transition towards real estate rather than a significant surge, which contradicts Krugman's hypothesis of a decline in investment patterns. It is important to note that the numbers may not entirely depict loan composition as borrowers can declare a loan is intended for expanding manufacturing capacity but instead use it to purchase real estate. Furthermore, the empirical evidence does not display the boom-bust cycle that Krugman defined. If there was a substantial amount of speculation, then real estate

prices should have spiked and declined rapidly in 1997. Table 6 demonstrates the stock and land values in two of the economies that suffered the most, Thailand and Indonesia.

Despite the increase in stock prices in Thailand, there has been minimal movement in property prices prior to the crisis. In Indonesia, there is even less indication of a cycle of economic growth followed by a slump. Non-performing loans (NPL) serve as another indicator of loan quality. NPLs have decreased from 1990 to 1996 in all Asian economies leading up to the crisis, though many underreport and go unrecognized until credit conditions become more stringent.

The quality of investment can be indicated by the incremental capital-output ratio (ICOR), found in Table 8. A rise in this ratio implies a decrease in investment quality. Although there are some issues with this measure, the general pattern shows a decline in investment quality. Other emerging markets, like Chile, also had an increase in ICORs without experiencing a crisis. However, countries that did undergo a crisis, such as Mexico and Turkey, had much bigger increases in ICORs (Radelet and Sachs 1998).

Although the data do not indicate that banks were engaging in reckless real estate lending or that investment quality dropped significantly, the rapid increase in loans during the period implies that these factors played a role in the crisis. Nevertheless, the financial system's weaknesses alone cannot fully account for what occurred. According to Radelet and Sachs (1998), financial instability exposed East Asian economies to a sudden shift in creditor expectations regarding other creditors' behavior, resulting in a self-fulfilling panic. Their work was informed by Diamond and Dybvig's (1983) theory of bank

runs, where rational individual investors may withdraw funds, causing financial institutions to collapse if done collectively. As a result of the panic, all depositors lose money, thus confirming their original motivation for withdrawal. A simple probit analysis is utilized to evaluate alternative risk indicators' relative strength in forecasting financial crises 11.

Among the indicators that reveal a country's risk level are its short-term debt to short-term assets ratio, and the ratio of total foreign debt to reserves. When a country has a high short-term debt to reserve ratio, its economy becomes more susceptible to financial panic. Another indicator is the private credit to GDP ratio, which shows how fast banks are accumulating credit. To test the hypothesis that a large current account deficit can lead to a financial crisis, we examine the "current account ratio to GDP" variable. We also consider the capital account ratio to GDP as an indicator of focus on capital flows. Other factors that contribute to risk include real exchange rate appreciation (RER) and corruption index.

Table 9 displays the outcomes which reveal that a high short-term debt to reserves ratio is closely linked to crises. This is supported by a positively significant coefficient at the 5% level, with an average ratio of 1.

According to Table 10, the ratio of long term debt to reserves is higher in crisis countries (82) compared to non-crisis countries (0.99). Although a high ratio does not necessarily lead to a crisis (as proven by the unaffected Asian economies during Mexico's 1995 crisis), it is an indication of vulnerability. Unlike the ratio, the level of long-term debt is not statistically linked to a crisis, and the difference

in average ratio between crisis and non-crisis countries is negligible. These findings suggest that liquidity issues, as opposed to solvency problems, caused the crises. The countries had the net worth to repay future debts but lacked the funds to settle short-term debt payments.

It is common for credit to rapidly accumulate before a crisis, with a positive and significant coefficient estimated at the 5% level. Table 11 shows that in crisis countries, the increase in claims to GDP rose by 17 percentage points, compared to only 4 points in non-crisis countries. While a larger current account deficit is weakly associated with a crisis, the coefficient is not significant at the 10% level. However, there is a stronger relationship between the capital account and crises, as it is the inflow of capital that causes pressure to build up, rather than the current account itself (Sachs 1998).

Despite being labeled a 'currency crisis', the RER does not seem to be linked with any financial crisis as the coefficient is insubstantial. Additionally, the corruption index is not a significant factor since extensive corruption exists in other emerging economies without crises. In summary, the conventional currency crisis models fail to justify the Asian crisis. Instead, Krugman's model suggesting a vulnerability in financial systems due to intermediaries' moral hazards partly explains the root of the complications.

Despite some of the assumptions of Krugman's model being disproven by empirical evidence, such as the boom-bust cycle not being as present as suggested, tests conducted by Sachs and Radelet show that a high ratio of short-term debt to reserves and the rapid accumulation of bank credit were key factors in East Asia's financial crisis. The

convergence of various factors led to a sudden reversal of capital flows, resulting in the collapse of financial institutions and businesses. This triggered widespread withdrawals, leaving governments unable to reconcile monetary and fiscal policy and rendering fixed exchange rates unsustainable. Although each individual investor acted rationally, the cumulative effect was detrimental, with a speculative attack on currencies serving as a contributing factor rather than the root cause of the crisis.

The exposure of insolvency in banks and financial institutions due to capital withdrawal has left economies vulnerable to attack.