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Newly revised version - April 27 2000
On the 2 July 1997, the Thai government announced the abandonment of the fixed exchange rate relationship between the Thai Baht and the US Dollar. This left the Baht a floating currency in international currency markets. In the weeks that followed, the Baht went into a downward spiral, falling around 30% by the end of September 1997. This was a surprising development for economic and financial market analysts throughout the global economy. Even more surprising however was the so-called “contagion” accompanying the collapse of the baht whereby the Indonesian rupiah, the Malaysian ringgit and the Philippines peso also suffered to a similar extent.
These massive declines in currency values and the accompanying flights of international funds from the countries concerned appeared to mark the end of what many observers termed the “Asian Economic Miracle”. For more than two decades, the economies of these countries had recorded rates of growth in GDP of the order of 7% to 9% per annum. As a group, they had taken on a role referred to by many as the “engine house of the world economy”. So successful had the economic policies of the region been that many Western economists had taken to analysing various measures to derive lessons for policy formation in the more developed countries. When the collapse came and spread so widely and so wildly through the region, financial analysts and economists throughout the world were taken completely off-guard. Most were astounded.
Causes
Why did this pattern of events occur and why so quickly? To answer this question, we need to go back to the conditions that gradually had emerged in the world economy over the preceding eight years. On this front, the dominating play of forces centred on the relative performance of the US dollar and the Japanese yen. The Japanese government had for some time pursued a policy of containment with respect to the crisis conditions that had hit the country’s financial sector in the late 1980s and early 1990s. The government attempted to stave off collapse of financial institutions through mainly macroeconomic management, imposing severe restrictions on fiscal policy and holding the monetary reins firmly. In the US, however, financial collapse had been tolerated for individual institutions and much had been done to reform the savings and loans sector. The Japanese had avoided substantial reform of the financial sector.
By the mid 1990s, the US economy was being allowed a fairly free rein, with inflation contained and the government budget under firm, though not severe, management. Economic conditions were quite buoyant. In Japan, the tight macro controls were taking their toll. The Japanese economy was stagnating. As a consequence, after 1995, the Yen began to depreciate against the US dollar, falling some 20% from 95 yen to the dollar in 1995 to around 120 in mid 1997.
For the countries of the South East Asian region, this movement in the value of the yen/US dollar exchange rate created a very real problem. An essential component of their economic growth policies was the maintenance of exchange rate stability. For Thailand, Malaysia and the Philippines, this was achieved by tying the domestic currency to the US dollar. For Indonesia, a managed exchange rate policy allowed the rupiah to decline in value against the US dollar, though on an artificially restricted basis. These policies resulted in the overvaluation of the region’s currencies, against the yen in particular. As a consequence, import prices for goods and services coming into South East Asia were artificially low, while the prices of the region’s exports to the world were artificially high.
These price discrepancies for traded goods resulted in continually worsening balance of trade deficits (an excess of import outlays over export receipts). As the yen continued to fall, the broadening trade deficits had to be financed in some way. Such financing of excessive foreign currency expenditure can occur in three different ways:
i. Through borrowing from overseas sources;
ii. Through using the proceeds of foreign investment coming into the
countries concerned; or
iii. Through the governments of the countries using their foreign currency
reserves to supply the foreign exchange market with the needed extra foreign
currency.
Effectively, all three sources were used by the South East Assign economies to one extent or another during the 1995-97 period. In Malaysia, government restrictions avoided heavy reliance on foreign debt, and most foreign commitments were in the form of direct investment. For the other three countries, however, the mix of sources that transpired was lethal.
Whilst foreign investment funds came into the countries over the period in question, unfortunately they did not do so in sufficient quantities to cover the requirements of the trade deficit. Thus, the governments involved chose to use official foreign exchange reserves, resulting in the depletion of these to dangerous levels by the time the collapse came in July 1997. Hence, increasingly during the period, borrowing of foreign currency by the private sectors in the three countries became the source of funds that covered the excess expenditure on imports. This borrowing was fuelled by conditions in the financial markets of the region.
As the South East Asian countries had achieved such enormous growth over a long period, their governments had come gradually to embrace the traditional policy attitudes of more developed economies towards financial market liberalisation. The decision to borrow from abroad had once been tightly controlled by government. In the new liberal era, private sector decision makers were free to organise such loans with little restriction. While reasonably robust prudential requirements on banks and finance companies did exist, these were not policed very effectively. Further, much of the borrowing was organised by non-finance sector companies and individuals who faced no prudential requirements.
These conditions in the financial sector were complicated by the traditional approach of individuals to doing business, and to their business relationships with other decision-makers in either the private or the public sectors. In the theatre of international trade, there is perhaps nothing more complex than the cultural underpinnings of varying business relationships between and within different societies. It is the mark of the successful international business operator that they have developed over time an understanding of the perspective of their foreign counterpart, and have, at a quite basic level gained the confidence of those coming from different trading cultures. Amongst the nations of South East Asia, these observations are as relevant as anywhere else in the world.
In most of the developed world, trading over the centuries has enabled a drawing together of business cultures across many different nations to the acceptance of an individualist performance ethic. As a consequence, financial markets are extremely open in that disclosure of a business’s dealings is necessary to gain the confidence of the market and access to market funding. Japan is arguably the pre-eminent developed nation in terms of GDP per head, but even there, significant gaps remain in European/American understanding of the “Japanese way” with its emphasis on non-individualist values. Japanese markets are not as open as those of the west and this hinders free western participation in the Japanese economy.
For the South East Asian nations these gaps in western understanding (and the reverse perceptions of the West by Asians) are even more obstructive to harmonious trade development. The nature of relationships between business operators within the South East Asian countries is characterised by deeply felt deference to notions of mutual trust, the saving of “face” and familial, ethnic or friendship ties. It is partly for this reason that the countries concerned have moved through the stages of their economic emergence at such a rapid pace, the sharing business culture acting to eliminate much of the uncertainty that characterises western individualist business relationships. Acting as a type of national business-economic club, the elite of these nations arranged business dealings and negotiated economic and other government policies for the mutual benefit of all. And they did this successfully over many years. Further, the “trickle down” effect of the arrangements to all levels of society is admired and commended throughout the western welfare sector.
However, in the relatively recent past, the pattern of this economic emergence in South East Asia took on a quite different nature. The basic economic forces of overvalued currencies and escalating trade deficits soon exhausted the capacity of foreign currency reserves and foreign investment and induced Asian banks, companies and nationals to seek loan funds from abroad. As the situation grew ever tighter, developed country lenders sought to protect themselves by shortening the terms attaching to their loans. The Asian borrowers, confident in the underlying strength of their fundamental relationships with government policy makers, assumed the protected arrangements for the values of their currencies against the US dollar would endure and hence they did nothing to insure against the chance of the local currency falling. Little and often no hedging of foreign currency loan obligations was contracted. When the situation neared crisis point, the western lending institutions were confronted with a serious situation:
i. They had very little knowledge of the business affairs of the banks and companies they had lent to as the details normally available publicly in the west were hidden behind the closed walls of traditional cultural loyalty that underlay business relationships in each of the countries concerned.
ii. As a result, western lenders who feared their financial stakes were at risk could not determine which, if any, of their borrowers were at risk and which were not.
iii. Hence, in a very short period of time, most lenders withdrew support and refused to renew short term loan arrangements to any of their borrowers.
Throughout the economies of South East Asia, a massive withdrawal of foreign funds occurred, resulting in a devastating collapse of asset markets for stocks, securities and real estate, and this in turn caused liquidity crises for investors in physical production such as manufacturers who found themselves struggling to finance day to day and longer term capital requirements.
The spread of this crisis from the initial downturn in the market for the Thai baht to the markets for the currencies of Indonesia, the Philippines and Malaysia was rapid because the uncertainty surrounding Thai loan obligations immediately called into doubt similar obligations/investments in the other countries. Western lenders were so ignorant of real business conditions and relationships in all countries that they could not even distinguish between national economies. Their confidence in their lending commitments was based on a general impression that the tightly closed system of mutually supporting relationships between and amongst the business and government communities in each country would be preserved and would protect the individual borrowers.
In South Korea, a far larger, more developed and seemingly more robust economy than those in South East Asia, there were similar forces at work (as, indeed, there still are in Japan, but more on that later). But the size and depth of the Korean economy held foreign lenders off, despite the fact that major groups such as Hanbo and Kia were allowed to collapse. In the end though, lack of individual company knowledge and the ever failing balance of payments situation led western lenders to lose their nerve here as well and the Korean currency followed the South East Asian currencies into a downward spiral.
Why the Surprise?
The history of international financial crises goes back a long way. In the aftermath of every crisis, the international financial community (the International Monetary Fund (IMF), the World Bank, the OECD and many other institutions) have worked extremely hard to determine what has gone wrong and what can be done to avoid a similar occurrence in the future. Generally, the various institutions have been able to find measures and instruments to achieve just that. Yet, again and again, new crises emerge, confounding the hopes and expectations of the policy makers that the system has been finally stabilised.
The last major crisis in the world economy involved the collapse of the Mexican peso. (It is sometimes referred to as the tequila episode/crisis.) Late in 1994, a crisis similar to that in South East Asia in 1997 occurred amongst foreign based lenders to Mexican banks and companies. Both the peso and the Mexican stock market collapsed. The International Monetary Fund and the US government stepped in to provide support by way of a multi billion dollar credit. The conditions for this support were stringent and extensive. The Mexican government complied and within 18 months the economy was restored on a path of solid growth with inflation rapidly coming under control.
The conditions imposed as an answer to the Mexican crisis involved a number of elements:
i. It is essential that government policy encourages a high savings rate in order to avoid excessive dependence on foreign sourced funds;
ii. In the event of extensive liberalisation of markets in the economy, steps should be taken to avoid “consumption splurges” brought on by tariff reductions , sales tax cuts, retail deregulation etc resulting in lower consumer price levels;
iii. Care must be exercised to avoid excessive expansion of the deficit on export and import trade - avoid excessive growth of import expenditure relative to export receipts; and
iv. Inflation to be avoided at all cost through strict control of the money supply in the economy.
During the mid 1990s, these conditions became automatic elements of the standard package of reforms urged by the IMF and the international community on emerging/developing economies around the world. Yet when it came to the South East Asian Economies in the period leading up to the 1997 crisis, the following prevailed:
i. While trade balances were moving into deficit, it was only in Thailand that this figure was reaching a critical level - the Thai Current Account Deficit stood at 8% of GDP in July 1997. For the other 4 nations, the figure was negative but nowhere near this level.
ii. Inflation in each of the five economies was well within control in the low single figures;
iii. Government budget policies were all centred on surpluses of revenue over expenditure, ensuring significant public savings rates;
iv. Private savings rates stood at remarkably high levels of between 25% and 40%; and
v. Governments were actively engaged in deregulation programs, moves toward the freeing up of foreign investment regulations and tariff reductions.
While there were some concerns expressed at the lack of rigorous banking supervision, somewhat excessive levels of foreign short term borrowing and excessive investment in real estate, the adjustments called for were marginal, aimed at easing up on these excesses. Currencies were thought to be overvalued perhaps by 10%, not the 30-70% by which they actually fell.
Essentially, the international financial institutions misjudged the extent of the impending collapse. As in the past, they have determined to unearth policy reforms that will ensure similar crises are avoided in the future.
The Implications for IMF Reform Packaging
The new policy scenario incorporates as a basic content those elements applied in the Mexican crisis, but adds several other provisions designed to overcome the information deficiency in the Asian markets that so drastically confused western lenders during last year’s crisis. These provisions include:
i. The institution of prudential requirements for the finance sector that match the rigorous regulations now accepted as standard throughout western countries;
ii. The institution of reporting requirements for all companies that match the reporting standards prevalent in western countries;
iii. The imposition of corporate governance requirements for all companies that impose strict responsibilities for the observation of “due diligence by board directors in the management of corporate activities;
iv. The introduction of rigorous standards of transparency to all arms of government policy formation and implementation to ensure open public knowledge of all government activities, particularly those surrounding the privatisation of public assets;
v. The removal of government controls on competition in any markets currently monopolised under the support of government decrees and legislation, in particular freeing up restrictions on the participation of western investment in domestic markets; and
vi. The institution of a court system covering commercial litigation and dispute that guarantees non-discriminatory treatment of domestic and foreign litigants alike.
The Outcome
During the implementation of various reform packages coordinated by the International Monetary Fund, the response of various governments has varied considerably. In Thailand and in Korea, domestic elections saw the passing of political power to new governments some months after these countries were hit by the crisis. This change of leadership enabled a much smoother transition to the new more open restructuring of financial markets and corporate governance procedures. As a consequence, both countries have moved quickly along the path towards recovery. Mexico, after adopting the IMF reform measures in a speedy fashion, achieved stability and strong growth within a 18 month period. A turnaround of similar strength and speed has occurred in Thailand and Korea, with GDP growth rates in 1999 of 6.5% AND 13.0% respectively.
The government of the Philippines had pre-empted a full blown crisis by calling on the IMF to assist with a reform package as early as 1996. Consequently, when the Thai crisis occurred, reform measures were well under way in the Philippines. The country’s currency did suffer under the region’s malaise, but, like the Thai baht and Korean won, is now recovering strongly. The expected growth in GDP this year is 5%.
In Malaysia, the government chose to weather the storm on its own, avoiding IMF intervention. This wisdom of this decision was queried by many western observers. The Malaysian government’s confidence in its control of the recovery stemmed from the absence of large scale foreign debt. It applied its own reforms and these have been praised by the IMF. And the Malaysian economy has responded accordingly, growing at 10.6% in 1999. This has confounded a lot of Western opinion on economic reform requirements in the wake of the crisis.
The country proving most difficult to turn around in the wake of the crisis, however, has been Indonesia. On three separate occasions, the IMF negotiated reform packages, each time rendering the measures involved more and more stringent. With the acceptance by the Indonesian government of the various IMF packages, observers everywhere have waited for signs that real implementation of the measures is in train. If the government ultimately fails to carry out the reform process, there is good reason to expect a continuing severe crisis in that country, perhaps extending for several more years.
For the world economy, the Asian crisis came at a time when the US economy has been particularly buoyant. This has limited the impact of the crisis on world economic activity. In Australia, where the economy is also very strong, the impact was more concentrated because of our geographical position. Even allowing for that, GDP still grew by over 4% in 1998 and at a similar level in 1999. Japan, with economic reform woes of its own, languishes with a GDP growth in 1999 of 0%. There is little sign of this malaise being overcome in the immediate future.
FURTHER READING
The International Monetary Fund
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