Chapter 1 Causesand Characteristics of the Asian Currency Crises
1. Developments andCauses of the Asian Currency Crises
The currency crisis that startedin Thailand spread to the neighboring countries of Southeast Asiaand eventually triggered serious crisis in the currency and financialmarkets of South Korea which had just recently joined the ranksof the advanced economies of the world. While there is a tendencyto speak of these crises which covered the entire region as asingle event and phenomenon, background factors and causes arenot necessarily identical among the affected nations. The crisesalso served to uncover serious structural flaws in these countries,including weaknesses in the financial sector, delays in vitaltransformations in the industrial structure, and defects in corporategovernance. The structural flaws are regarded as a major factorin obstructing the return to stability by the affected currencies.
It would be useful to reviewat this point the various causes leading up to the crises andsubsequent developments(see Appendix 1).
(1) Events Leading tothe Thai Currency Crisis
On July 2, 1997 the Thai bahtwas untethered from its virtual dollar peg and allowed to go intoa float. The precipitous devaluation of the baht which followedthis move triggered the Asian currency crises. The baht had actuallyweathered several sell-offs since 1996. The monetary authoritiescountered these earlier incidents with market intervention andtight-money policies. However, by July 1997, these measures wereno longer viable because the monetary authorities did not havesufficient usable foreign reserves left to commit to protectingthe baht. Beyond this point, Thailand was incapable of maintainingits dollar-peg foreign exchange regime.
The baht came under sellingpressure because confidence in the baht had been lost in the Thaimarkets. This loss of confidence is generally attributed to thefollowing factors.
[1] Overvaluation of the Currency
Although the Thai baht was "pegged to a basket of currencies,"in reality it was linked to the dollar. Consequently, the appreciationof the dollar beginning in the spring of 1995 led to the overvaluationof the baht(see Appendix 3). This was one of the principal reasonswhy the growth rate of Thai exports plunged in 1996(see Appendix5).
[2] Massive Current AccountDeficits
Thailand was registering substantial current account deficitssince 1995 (the current account deficit/GNP ratio rose from 5.6%in 1994 to 8.0% in 1995 and 7.9% in 1996). The problem was thatThailand had scant prospects for rectifying this imbalance becausethe nation's industrial structure was not being adjusted fastenough to absorb the rise in labor costs engendered by rapid economicgrowth, and the domestic production of capital goods remainedunderdeveloped. Additionally, Thai exports were being increasinglythreatened by competition from China and other less developedcountries. The economic growth rate began to falter in 1996, givingrise to an increasingly pessimistic outlook.
[3] Inflows of Short-Term ForeignCapital
During this period, Thai interest rates were substantially higherthan rates in the advanced economies. Given this condition, thedollar-peg regime facilitated the massive inflows of short-termoverseas capital. Part of these capital found their way to financecompanies and was invested in real estate and other assets. Thisgenerated an asset-bubble phenomenon which left financial institutionswith a serious problem of non-performing assets when it ultimatelycollapsed. It is reported that some of the short-term funds whichwere loaned to the BIBF created in 1993 were also used to financeasset investments.
[4] Failure of Financial Institutions
Certain financial institutions began to fail in the spring of1996. Because of inadequate disclosure, the entire financial sectorbegan to suffer a serious deterioration in confidence at thispoint.
[5] Selling Pressure from Speculators
Against this background, the market began to view the Thai foreignexchange regime as essentially unsustainable. In the process,hedge funds and other speculative sources applied growing pressureon the baht by taking short positions in the forward markets.Ultimately, the monetary authorities could not resist the pressuresof the market.
To summarize, while it is truethat failures of financial institutions and speculative pressuresdid play a role in generating the crisis in Thailand, the principalfactor responsible for the collapse of the foreign exchange regimewas the unsustainability of the macroeconomic imbalance. On thispoint, the Thai crisis can be said to resemble the Mexican currencycrisis of 1994, with the exception that government liabilitieswere the problem in the case of Mexico as opposed to private bankingliabilities in the case of Thailand.
Even after a floating exchange-rateregime was instituted in July the baht continued to lose ground,forcing the Chavalit Administration which was then in power toseek the International Monetary Fund (IMF) support on July 29.The IMF responded by issuing a call for assistance to other Asiancountries. On August 11, Japan hosted a meeting of supportingcountries and a assistance package centered on the IMF was finalizedon August 13. However, political conditions in Thailand remainedunstable even after the IMF agreement. Gasoline taxes which hadbeen raised to improve the government's finances were loweredand the minister of finance announced his resignation on October19. Developments in neighboring countries where the crisis wasnow spreading had by this time become an additional source ofinstability. Under Prime Minister Chuan who took office in November,the government took bold measures to conform to the IMF agreement,including the reorganization of financial institutions. (For instance,the program for financial reconstruction announced on December8 contained measures for closing down 56 of the 58 finance companieswhose operations had been suspended.) Such measures have beeninstrumental in significantly bolstering market confidence. Hence,although the baht marked its lowest point in early 1998 affectedby falling currency values in neighboring countries, it has sincethen regained its stability.
(2) Crises Spill Overto Neighboring Countries
The Thai currency crisis andthe ensuing turmoil in its financial markets spread to neighboringcountries within a few weeks. Indonesia, Malaysia, and the Philippinesfelt the direct impact of the spreading crises, while Singapore,Taiwan, and Hong Kong were affected to a lesser extent.
Following the devaluation ofthe baht, on July 11 the Indonesian government broadened the bandin which its currency was allowed to fluctuate. On August 14,the band was abolished to be replaced by a float. The Philippineshad already abolished the band on July 11. In this manner, thecurrencies of Indonesia, the Philippines and Malaysia lost groundin step with the devaluation of the baht. Concurrently, stockprices in these countries were declining. Currency values andstock prices were also declining in Singapore and Taiwan, butto a lesser degree.
Macroeconomic conditions inthese countries did not appear to warrant the currency and financialcrises. Moreover, unlike the case of Thailand, there had beenno signs of impending trouble in their markets in advance. Amongthese countries, economic conditions were widely dissimilar interms of economic and industrial structure. Some remained highlydependent on primary products while others numbered hi-tech productsamong their principal exports. By the same token, per capita GDPlevels were highly disparate.
Notwithstanding these essentialdifferences, the turmoil in the currency and financial marketsspread very rapidly to all of these countries. This "contagion"effect can be primarily attributed to the radical shift in marketperceptions of the currencies of these countries following thecollapse of the baht. These countries were particularly susceptibleto shifting market perceptions because, in the course of rapideconomic development, the economic linkage among them has beenstrengthened as a result of growing intra-regional trade(see Appendix8). The markets had already placed Indonesia, the Philippines,and Malaysia where the contagion spread with particular virulenceunder close scrutiny for the following reasons.
[1] Currency Overvaluation
While some differences existed in the form of each country's linkageto the dollar, the steady appreciation of the dollar had substantiallyelevated real effective exchange rates in all of these countriesand the loss of export competitiveness was a growing concern.Thus, as in the case of Thailand, these countries were being threatenedby competition from China and other less developed countries.
[2] Export-Oriented EconomicStructure
Without exception, these countries had opted for export-orientedeconomic structures (see Appendix 9) which rendered them vulnerableto the loss of export competitiveness (through exchange rate appreciationand higher labor costs).
[3] Growing Short-Term ForeignDebt in the Private Sector
Past growth policies had encouraged the introduction of foreigncapital and funds which led to ballooning private-sector debts.Particularly worrisome was the accumulation of short-term liabilities(especially in the case of Indonesia).
[4] Structural Issues
The crises exposed the structural issues inherent in family-typebusinesses and other corporate forms where adequate attentionhad not been paid to economic viability. Such arrangements invitedover-investment financed by a financial sector lacking in transparencyand marred by various weaknesses.
In the case of Thailand, thecurrency crisis of July 1997 did not necessarily come as a surprisebecause pressures on the baht were mounting since 1996. But therehad been no advance signals in the markets on the other countriesof the region. In that sense, the massive spillover of the Thaicurrency crisis and the ensuing impact on the economies of thesecountries went beyond all expectations.
The currency and financialturmoil in Southeast Asia introduced an element of instabilityin the international movements of capital, the effects of whichextended to Hong Kong which functions as a principal internationalfinancial market. In late October, the Hong Kong stock markettook a precipitous plunge (losing 10% of its value on October23 and 13% on the 28th). The effects of this drop were felt inNew York and other leading stock exchanges. At this point, theAsian currency and financial crises came to be viewed as a globalproblem.
(3) Crisis Hits SouthKorea
The Asian currency crises becameeven more ominous when it reached South Korea in late October.However, the causes of the crisis in South Korea appeared to differsignificantly from those in Indonesia and other countries earlieraffected by the contagion.
While there is no questionthat the South Korean currency crisis was in part instigated bythe growing market instabilities engendered by the broader Asiancrises, it should be noted that various problems related to SouthKorea's industrial structure and its financial sector had surfacedwell in advance of the currency crisis. Although macroeconomicconditions indicated that South Korea was slowly overcoming economicstagnation and moving toward recovery since the second quarterof 1997, problems related to over-investment by the major conglomerates("chaebols") and the accumulation of non-performingloans by financial institutions--which had financed this investmentbinge--were becoming increasingly apparent. Beginning with thecollapse of the Han-Bo Group in January 1997, South Korea faceda growing list of business failures among its chaebols.This trend reached a climax in July with the failure of the KiaGroup, South Korea's eighth largest chaebol. This stringof major business failures raised growing concerns about deteriorationof the asset structure of the financial institutions which hadfinancially supported these corporations. Concurrently, merchantbanks (non-banks) were experiencing serious management difficultiesin their aggressive fund management--using short-term overseasfunds--at home and abroad.
These developments rapidlyeroded confidence in the South Korean economy. Foreign investorswho had become increasingly concerned with the possibility ofnot being able to recover their investments as a consequence ofthe Asian currency crises opted to pull out their funds from SouthKorea at a highly accelerated pace. Acting to prevent the collapseof the financial sector, the South Korean monetary authoritiesimplemented several measures for stabilizing the financial marketbetween August and November and used the nation's foreign reservesto shore up the financial sector. The point of reckoning arrivedin late November when support measures became no longer effectiveand South Korea turned to the IMF and the international communityfor support.
The capital outflows continuedeven after the agreement was reached with the IMF, as market confidencewas hardly recovering due to the unstable situation with the imminentpresidential election on the political side. Conditions in SouthKorea finally stabilized, however, after the following favorabledevelopments: [1]Political doubts subsided when the transitionof power was proceeding smoothly after the election of the newpresident, and the president-elect voiced his strong determinationto go through with the implementation of the program; [2]the schedulefor the financial support package from the IMF and leading countrieswas moved up; and [3]an agreement was reached with the principalbanks for Japan, the United States and Europe for consideringthe restructuring of short-term liabilities.
(4) Developments inIndonesia
Among all the countries wherethe contagion spread, the most seriously affected was Indonesia.The Indonesian rupiah fell even further than the Thai baht. Currencydevaluation increased the debt burden of foreign-currency denominatedprivate borrowings and cast doubts on the ability of Indonesiato honor its outstanding debt. This gave rise to growing marketuncertainties which in turn triggered a new round of currencydevaluation in what became a highly detrimental vicious cycle.For this reason, although foreign reserves had not dropped toa crisis level, Indonesia finally decided to turn to the IMF forsupport in October as a precautionary move.
On October 31, an agreementwas reached with the IMF for the implementation of an economicadjustment program. The situation was stabilized only for a shortperiod after the agreement. Thereafter, the market again fellprey to doubts as President Suharto was rumored to be in ill healthand the Indonesian government failed to show determination inthe implementation of the economic adjustment program. (For instance,a bank owned by family members of the president was closed onlyto resume operation under the guise of a different corporation.)Consequently, the rupiah again started to fall sharply in December.Unstable conditions have persisted through the end of January.Particularly devastating was the draft budget announced on January6 which was based on extremely optimistic assumptions (economicgrowth for 1998 was targeted at 4% as compared to the IMF projectionof 3% made at the end of October 1997), including an exchangerate of 4,000 rupiah per dollar (as opposed to a rate in the 6,000rupiah range at the end of 1997). In addition, the budget didnot contain provisions for achieving a fiscal surplus equivalentto 1% of GDP as agreed upon with the IMF. Following these revelations,the market exhibited a growing sense of mistrust in the government'swillingness to implement the necessary economic policies. On themonetary front, the Indonesian situation differed somewhat fromthe South Korean case of banks being saddled with foreign debtand was more difficult to grasp because the principal problemconsisted of foreign-currency denominated borrowings by privatecorporations.
A new policy package was agreedupon with the IMF on January 15 but the market remained stronglysuspicious of the prospects for implementation, particularly withregard to the abolition of monopolies and subsidies and otherreforms of deeply rooted elements of Indonesia's economic structure.Another cause for concern was that the agreement did not containprovisions for alleviating the problem of private-sector debts.These factors combined to force a further steep decline in thevalue of the rupiah. A framework for addressing the issue of private-sectordebts was formulated on January 28. However, market instabilitypersisted when negotiations on this matter did not necessarilyproceed smoothly and as the decision by the president to seekre-election spawned new speculations on the choice of a vice president.Prime Minister Hashimoto visited Indonesia in mid-March, and newprogress was made in negotiations with the IMF concerning policyprograms and an agreement was reached on April 8 for modifyingand fortifying the reform program. With these positive developmentsand with growing hope that the negotiation on private-sector debtswill progress, the rupiah showed signs of stabilizing. At thiswriting (May 15), however, the social and political turmoil isgetting more serious, following the announcement of the rise infuel prices on May 4. The situation does not allow premature prediction.In the subcommittee, concern was expressed that that such a disturbancein Indonesia may affect neighboring countries.
BOX -- Impact ofthe Asian Currency Crises
1. Impact on the WorldEconomy
Because of the increasing weightof Asia in the global economy(see Appendix 13), the Asian currencyand financial crises and the ensuing deterioration in economicconditions has had a considerable negative impact on the worldeconomy. Although the gravity of the impact differs among regionsand countries, the crises have made itself felt throughout theworld by affecting the international flow of trade and investment.
(1) Impact on the JapaneseEconomy (see Appendix14)
[1] Trade
The growth of Japanese exports to this region has stagnated asa result of slower economic growth and weaker demand in the Asianeconomies. (Japanese exports to the four ASEAN countries and SouthKorea went from an increase of 9.3% over the previous year inthe first half of 1997 to a 4.2% decline in the second half. Exportsto this region accounted for 17.6% of total Japanese exports during1997.) Weak Asian demand may have contributed to lowering internationalcommodity prices, and Japanese imports were reduced by the lowercost of oil. On the other hand, weak Asian demand has also depressedJapanese exports of steel and other products. On another front,the devaluation of Asian currencies might boost the competitivenessof Asian products, and might lead to increased Japanese importsfrom this region and more intense competition in third-countrymarkets.
[2] Impact on Companies Operatingin Asia
The impact of the currency crises on Japanese companies operatingin the Asian region differs according to the type of activity,such as production and marketing, that they are involved in. Companiesusing imported materials to manufacture in Asia for the Asianmarkets stand to suffer a deterioration in profits due to higherproduction costs and stagnant demand. In some cases, manufacturingoperations have been slowed down because the import of materialshas been disrupted by difficulties in fund raising. On the otherhand, companies which locally procure their inputs have not beenso seriously affected. Finally, companies exporting to marketsoutside the Asian region can expect to enjoy a growth in exportsas their competitive positions improve.
[3] Economic Growth
The Asian economic turmoil coincided with the failure of somemajor Japanese financial institutions. These two developmentscombined to depress consumer and business confidence and actedas one of the factors propelling the Japanese economy furthertoward a recession. Estimates of the negative impact of the Asiancurrency crises on Japan's 1998 GDP are as follows: minus 1.3%according to the OECD (Economic Outlook 63, April 1998), and minus0.75% according to the IMF (World Economic Outlook, April 1998).
[4] Lending
According to the BIS statistics on international claims, lendingby Japanese banks to the four ASEAN countries and South Koreaamounted to $97 billion as of the end of June 1996. There hasbeen some concern that parts of these loans might become non-performingassets as the corporate performances of Asian companies deteriorate.However, it is generally believed that the damage to Japaneselenders may not be serious. This view is based on a belief thatthe bulk of lending by Japanese financial institutions has beendirected to subsidiaries of Japanese manufacturing corporationsand blue-chip local corporations.
(2) Impact on OtherRegions (Europe, North America, South America)
The impact on other regionsis expected to be not as serious as the impact on Japan. Nevertheless,through the same types of channels, the Asian currency criseshas affected Europe and North America which in recent years havedeveloped closer ties with Asia. Similarly, South America, theother wing of the emerging market economies of the world, havealso felt the impact of the crises.
[1] According to the OECD estimatescited above, the Asian currency crises are expected to reduce1998 GDP growth in the United States and Europe by 0.4% each,primarily through its impact on trade.
[2] The loss of confidencein emerging market economies is affecting the international capitalflows. Specifically, risk averse capital is being repatriatedto the United States and Europe ("flight to safety").This may have contributed to the decline of long-term interestrates and bond yields.
[3] In the United States, itis reported that falling import prices have a welcome dampeningeffect on the overheating of the economy, at least for the shortterm.
[4] The trade and investmentimpact on South America has been minor because of its relativelylimited exposure to Asia. Nevertheless, currency values have showna downward trend in some South American countries whose currenciesare linked to the dollar. The depreciation has been caused byshifting market perceptions resulting from the association ofthese emerging market economies with those of Asia. Brazil andsome others have responded to this development by taking preemptivemeasures, such as raising interest rates and tightening fiscaloutlays. Thus, while the impact on currency and financial marketshas been marginal, some South American countries are sufferingsuch side effects as sagging domestic demand and increased unemployment.These developments may exert an impact on the United States.
[5] With regard to Europe,it should be noted that European financial institutions have agreater exposure to Asia than their Japanese and American counterparts.Furthermore, Europe will suffer indirect damage should the effectsof the Asian crises spill over to Eastern Europe and Russia. Incidentallyfinancial institution exposure to Asia is largest in Europe (particularlyGermany, France and Britain), followed by Japan and the UnitedStates in that order. However, the impact on lenders will varyaccording to the content of individual portfolios and the extentto which the risks have been hedged.
2. Impact on Asia
(1) Impact on the RealEconomies of the Asian Countries
While the situation variesfrom one country to another, the Asian economies in general facesevere economic prospects as a result of the economic turmoiltriggered by the collapse of currency values and the implementationof tight-monetary and tight-fiscal policies prescribed in theIMF adjustment programs. These conditions are not limited to Thailandand Indonesia but extend all Asian countries, including even Laosand Myanmar.
[1] As the non-performing loanproblem has become prominent, financial institutions have foundit difficult to raise funds in the market. In turn, it is reportedthat this development is causing a credit crunch. The deteriorationin corporate performances mentioned below is generating additionalnon-performing assets and has set off a vicious cycle.
[2] Corporate performancesare deteriorating and the number of bankruptcies is increasing.Factors contributing to this development include the following:currency devaluations have added to the servicing costs of foreign-currencydenominated liabilities; devaluations have spurred inflation byboosting import prices; real estate and stock markets have beenadversely affected by high interest-rate policies; financial institutionsare restricting their lendings; and, management of local companies(particularly small and medium-sized enterprises), having no overseasaffiliates (parent companies or foreign partners), have deteriorated,often leading bankruptcy.
[3] The deterioration of corporateperformances has set off a wave of lay-offs and production adjustments.Growing unemployment has further dampened consumption and depressedproduction.
[4] The downturn in the domesticeconomies and the slowdowns in trade and finance have, up to thepresent time, had a negative impact on export growth rates. Importshave also lost momentum as a result of rising import prices, sluggishdomestic demand and the deterioration in funding conditions.(seeAppendix 7)
(2) Developments inHong Kong, China, and Taiwan
The turmoil in the Asian currencyand financial markets has had a relatively small impact on HongKong, China and Taiwan. Developments in these areas can be summarizedas follows.
[1] In the case of Hong Kong,the turmoil in the Asian financial markets triggered a steep dropin stock prices and a dampening effect on economic growth ratescannot be avoided. Nevertheless, the monetary authorities remaindetermined to maintain the dollar peg. Reasons for this choiceinclude the availability of adequate foreign reserves and thebelief that the dollar peg is an indispensable element in maintainingconfidence in Hong Kong as an international financial center.
[2] In the case of China, therenminbi has actually been gaining strength against the dollar.Monetary authorities have repeatedly and formally denied speculationsthat the renminbi will be devalued to maintain China's exportcompetitiveness. Reasons for this policy position include thefollowing: China has adequate foreign reserves and enjoys sizabletrade surpluses, while capital transactions remain regulated;a devaluation of the renminbi would regenerate downward pressureson the value of Asian currencies; and, devaluation would havean adverse effect on China's foreign liabilities. It was notedthat macroeconomic conditions in China are favorable and the Chinesepresence in Asia will continue to become stronger in the future.On the other hand, its export growth rate is sagging (export growthhas slowed down from 26.3% in the first half of 1997 to 17.0%in the second half) and it continues to face various tough challenges,such as restructuring state-owned enterprises and reforming thefinancial sector. Therefore it was noted that China's economicconditions and currency related developments would have to becarefully monitored.
[3] In the case of Taiwan,the currency lost some ground in the Asian currency crises. However,the devaluation was relatively minor. Taiwan continues to enjoya high growth rate as domestic demand remains firm. Taiwan hasbeen relatively unaffected by the crises for the following reasons:Taiwan has adequate foreign reserves and relatively small amountsof foreign debts; the economy has adjusted itself to the productionof higher value-added products; and, the industrial structureis sound and is supported by a large population of small and mediumsized enterprises.