Twenty years ago in July a run on the Thai currency (Baht) triggered a financial crisis which quickly engulfed the entire region. Countries very severely affected were Thailand, Indonesia, South Korea, Hong Kong, Malaysia, Philippines and Laos. Other countries in the region such as Brunei, China, Singapore, Taiwan and Vietnam also experienced significant downturn in their economic activity. Even Japan had endured some fallout from the crisis.
The Asian Financial Crisis was marked by a series of currency depreciations (typical symptom of an exchange rate crisis - one version of a financial crisis but it then also spread to the banking sector) across a number of East Asian countries, the so-called "tiger economies''. The currency market collapsed in Thailand first when the Thai government decided to unpeg the local currency from the US dollar (i.e. allowed to float) due to the lack of foreign currency reserve to support the peg.
The pegged exchange rate encouraged very large capital inflows into the country. As the Thai currency went on a free fall, foreign creditors started to pull out from other countries in the region seen as having similar situation that created a run on those currencies. This is called contagion effect. The result was a very large proportion of East Asia currencies plummeted by close to 40 per cent. International stocks also fell by 60 per cent. The depreciation of the currencies meant that foreign currency-denominated liabilities grew substantially in terms of the domestic currency, causing more bankruptcies leading to further deepening of the crisis.
All financial crises usually begin with asset bubbles. Rapid economic growth was achieved by countries in the region largely by mobilising resources which led Paul Krugman to comment "Singapore grew through a mobilisation of resources that would have done Stalin proud". (see his book The Myth of Asian Miracle) Overall, he did draw parallel to the East Asian growth model to that of the former Soviet Union. Krugman was fairly right in his opinion given that East Asian countries did limit civil liberties and worker rights, engaged in industrial planning and import restrictions, and above all, depressed domestic consumption to cause high levels of domestic saving.
But it was also based on export push which led to very high levels of foreign investment. This also helped to depress domestic consumption. Up until the crisis East Asian countries attracted half of capital inflows into developing countries. This in turn led to soaring real estate values, increased investment spending and very large infrastructure investments. Most of these investments were undertaken by borrowing from banks. Obviously the surge in investment flows made these countries vulnerable to a financial panic. The situation further exacerbated when countries in the region accumulated a significant amount of liquid liabilities backed by illiquid assets further adding to their vulnerability to the panic.
Although East Asian economies seemingly pursued sound fiscal policies, yet these countries experienced run on their currencies and financial systems. By the mid-1990s, a series of external shocks began to change the economic environment in the region. These shocks include the devaluation of the Chinese and the Japanese currencies and most importantly, raising of the US interest rates which led to stronger US dollar and a sharp decline in the prices of many electronic components. But these shocks did not lead to a normal cyclical downturn, rather led to runs on the financial systems and currencies - a very typical example of a financial panic. This lends support to Joseph Stiglitz who downplayed the role of the real economy in the crisis compared to the financial markets.
As the crisis began to unfold, it became clear that the strong growth performance of these economies had masked many structural weaknesses. Absence of capital controls led to an influx of "hot money" to earn higher returns relative to developed economies. Definitely these investors were encouraged by the World Bank report of 1993, "The East Asian Miracle'', praising these countries' growth performance. But the financial systems in these countries were weak to prudently deal with such influx of foreign capital, especially short-term flows. The weakness in the financial systems is deeply embedded in the business and political culture in most Asian countries. Financial intermediaries most often voluntarily or under pressure did not use business criteria in allocating credit.
In many cases well connected borrowers could not be refused credit. In other instances, poorly managed firms could obtain loans because they meet some government policy objectives. Furthermore, financial intermediaries (whose owners always have strong political connections) do not have incentives for effective risk management because of implicit or explicit government guarantees against failures. Krugman pointed out that such guarantees can trigger asset price inflation and can lead to the collapse of the financial system. Financial sector vulnerability was further increased by currency pegging which was interpreted as implicit government guarantees against exchange rate volatility risks. So there no foreign-currency hedging mechanism was put in place in these countries.
The Asian Financial Crisis of 1997 clearly showed weaknesses in the financial sector were the principal contributor to the crisis, In the wake of the crisis there have been attempts to clean up and strengthen financial systems. The crisis also prompted many countries to adopt more protectionist measures, including capital control, with the aim to stabilise the currencies. Over time these economies stabilised.
Over the last decade there has been massive influx of capital into developing countries mostly triggered by quantitative easing (QE) in leading industrialised countries like the USA, Japan and Germany. This surge in outflows into developing and emerging markets are leading to increased corporate borrowing attracted by low borrowing costs. This in turn is increasing their foreign exchange exposure. It is now estimated that dollar debts outside the USA now stands at US$ 9.0 trillion. The US Federal Reserve has already signalled that it would start unwinding QE in September this year with the staggered sale of bonds it bought since the launch of QE in 2008.
There is increasing fear that a second Asian financial crisis may be in the making. Gradual slowing down of the Chinese economy and negative interest rates in Japan led to heavy borrowing to invest in global equity markets. But Japan counterintuitively responded by increasing the value of its currency, Yen, making its exports more expensive thus further weakening the economy. Now all the warning signs are there with one difference: this time both East Asian countries and the West will be in it together, the former, however, bearing most of the brunt.
The writer is an independent economic and political analyst.
muhammad.mahmood47@gmail.com