The Asian Financial Crisis of 1997 - Essay Example

Asian financial crisis Student’s Name: Course Code: Tutor’s Name: Date of Submission Executive summary These reports have analyzed the background of the Asian financial crisis and trying to understand the whole development process of financial crisis. We also try to research and study the causes of internal and external factors of the Asian financial crisis and the effects of the financial crisis on the economy. The report has taken into account the experience and the lesson from asymmetric information to analyze the causes of the Asian financial crisis and the economic recession to prevent such a crisis from happening again and improve the world financial system. The report has looked into details how the Asian financial crisis spread from Thailand to other South East Asia countries. The major causes of the financial crisis have been found to include low interest on foreign capital, fixed exchange rates in the affected countries among others International. The report has analyzed how the crisis affected other financial markets in the region and other countries outside the region such as Australia. The report has shown how monetary policy, structural reforms as well as fiscal policy can be used to prevent such a situation. Sound macroeconomic policies need to be put into place to prevent such a crisis and this has been looked into by the report Causes of the Asian financial crisis of 1997 Low interest on foreign funds International Monetary Fund (2006) says that initially there was a boom cycle in all the affected countries which were characterized by the availability of foreign funds in a relatively low interest. Investors who were searching new opportunities shifted huge amounts of capital in Asia. This made real estate as well as stock prices to increase considerably and the region attracted more and more funds. There were weak banking system and poor corporate governance as well as lack of transparency in the financial sector. Due to these factors the borrowed foreign resources were not allocated efficiently (Lee and Changyong 2012). The inefficient allocation was further triggered by the limited absorptive capacity of the affected countries leading to a situation of huge foreign debts. Fixed exchange rates During the boom cycle, these countries’ exchange rates were effectively fixed. The situation encouraged borrowers to continue taking more dollar dominated debts without knowing that the foreign debt will affect the economy negatively (Reinhart and Kenneth 2011). The borrowers had a false feeling of security making them continue taking more debts without considering their domestic currency reserve. Eventually, in the mid-1990s, all the international reserves in these countries had been committed in the forward market in the forward market, but the IMF believed that the countries had enough reserves until in 1997 July when they were nearly depleted and the governments sought for help (Colin & Francis 2003). Low exports According to Samuel (2001), the affected countries had weak exports during the period. This was caused by a number of factors, including the appreciation of the US dollar in relation to the Japanese Yen. The establishments of North America Free Trade Agreement made the demand of products from these countries reduce significantly. In 1994, China had devalued its currency something that made their exports cheap and buyers would opt to buy from china other than the affected countries (Sumarto and Suryahadi 2005). These factors made the affected countries to have current account deficits and this triggered the crisis significantly. Credit withdrawal There was panic among the foreign countries that were lending money to the affected countries. This made them to withdraw their lending, causing bankruptcies and sudden decrease on available loans making the affected countries’ currencies dominate the exchange market (Sumner and Wolcott 2009). Investors in these countries tried to withdraw their money from the affected region affecting the circulation of foreign currency in the countries. Due to this and prevention of domestic currency from collapsing, the governments in the affected countries increased their domestic interest rates for them to prevent the outgoing of capital but this never worked since the crisis was already rooted (Sumarto, Suryahadiand Bazzi 2008). Investors’ erosion World Bank (2000) argues that as the affected countries tried to struggle in solving the sudden crisis, investors were constantly moving away due to speculation of currency devaluation. The government of Thailand did away with the efforts to maintain a fixed exchange rate of its currency. This made the baht to depreciate by more than 20 per cent. Neighboring countries followed the trend and devalued their currency. The countries consumed all the foreign exchange reserves meant to defend their exchange rates. The economic fundamentals of the affected countries suffered great imbalances which included deficits in the current account making foreign investors to move away in search of better opportunities. There were huge foreign debts accompanied by huge domestic bad debts as well as budget deficits, which were the main reason of the crisis (Zakari, Hussin, Noordin, & Sawal, 2000). Increase in foreign borrowing There was a significant increase in foreign borrowing where domestic banks and private corporations increased their rate of borrowing in the affected countries. The outstanding debt to foreign banks of the affected countries increased from $ 210 billion to $ 260 billion in the year 1996 (World Bank 2000). The banking sector shot from $ 91 billion to $ 155 billion in the same year (International Monetary Fund 2009). Short term liabilities were even bigger because the countries were taking the loans to finance domestic investments and other activities which were non-tradable. The danger here was as a result of borrowing in foreign currency and lending using the local currency, making the banks vulnerable to the crisis effects. There were the risk losses which come as a result of depreciation even though local loans were in dollars. Effects of the crisis on international markets Australia trade deficit. The crisis shocked australi’as primary commodity trade by two channels. Firstly, there was capital flight which precipitated local cuurencies’ depreciations in the affected economies. Due to this, there was a reduction in domestic investment and decrease in demand for capital goods (Yu & Xu 2007). Ther was contraction in the affected economies while currency depreciation expanded the debt volume in foreign currencies such as Australia which is a major trading patner of the affected countries. Additionally this caused capital account surplus in non crisis countries Australia included. The second channel was characterized by reduction of the Asian imports from Australia and an increase in Australia’s imports from asia due to currency devaluation.this means some there was compositional effect in that some sectors in Australia economy will expand and others will contact due to the crisis (World Bank 2000). Credit withdrawal Foreign investors withdrew their credit from the affected countries due to panic. This increased the bankruptcies with the exchange market flooding with currencies of the affected countries. Domestic interest rates were increased to prevent the collapse of the currencies and to make lending more attractive to potential investors. South Korea, for example was negatively impacted by these changes with its GDP reducing by 6.5 per cent in 1998(Zubair 2003). The level of inflation rose by 75 per cent and unemployment by 6.8 percent (Noble and Ravenhill 2000). Poverty levels grew significantly than the preceding years. Economic impacts The economy of the affected countries was negatively impacted. In Malaysia for example, the value of ringgit declined from 2.42 in April 1997 to 4.88 comparing with US dollar after the crisis (World Bank 2000). The index of Kuala Lumpur Stock Exchange decreased significantly from 1,077.3 in June 1997 to 262.7 points in January 1998 (World Bank 2000). The stock exchange was the largest in the region and its depreciation was a big blow to investors. There was a general contraction of domestic demand in the region characterized by deprivation of currency, weak stock prices and the property market slump which resulted to a negative wealth effect. IMF reputation IMF reputation was greatly affected by the crisis. The fact that it had failed to give the affected countries last resort when it was needed most made it to lose credibility and authority over many countries in the world. The institution had the power and influence over the economic policy of the area, but it was too late to act. The impact of this crisis made IMF’s loan portfolio to shrink from $96 billion $20 billion with the Turkey being the highest beneficiary (Colin & Francis2003). The closure of sixteen Indonesian banks by the IMF with the aim of restoring confidence in the banking system made the institution to lose credibility. Depositors withdrew from the remaining banks and this destabilized the financial system further. Several countries in the affected region withdrew their membership from IMF (Lee and Changyong 2012). Learnt lesson The macroeconomic policies responsible for the crisis were greatly rooted in the affected countries but some issues would have been solved amicably using monetary policy, fiscal as well as structural reforms (Lee and Changyong 2012). Monetary policy Reinhart and Kenneth (2011) say that the collapse of affected countries’ currency was the first manifestation of the crisis. Using monetary policy was very important for their reform programs. During recession, the lowering of interest rates will reduce the exchange rates and boost the economic activities in the region. In order to arrest the deterioration of exchange rates, the countries would pursue an increase in interest rates and then reduce the rates gradually as the exchange rates stabilizes. Banks in the affected countries were reluctant to roll over their credits (World Bank 2000). They had numerous non-performing loans and a weak corporate sector. A good example can be drawn from Japan where interest rates have been zero for some time while the economy is facing a credit crunch. Fiscal policy At the beginning Asian countries were in a good position as far their budgetary positions were concerned. However, as economic conditions worsened, the fiscal targets were adjusted to become stable and to finance the social spending so as to protect the poor. The fiscal targets of the affected countries were showing substantial deficits and fiscal tightening was largely misplaced (Reinhart and Kenneth 2011). Structural reforms There was a weakness in the financial and the corporate sectors in the affected countries. Lack of transparency and inadequate governance triggered the crisis greatly. There was the need for the governments to show their awareness on the problem and how to solve in order to regain the investors’ confidence. Relevant authorities took advantage of the crisis to push for important reforms thorough out the affected areas (Samuel 2001). Additionally, the crisis was solved from external sectors based on the strong US economy together with the recovery by Asian economies. The intra-regional trade makes a substantial part of the affected countries’ exports. The recent recovery of the Asian economies as well as the Japanese economy played a major role to benefit these countries. Exports from the region were very competitive in the global market and this made the region to recover the crisis favorably (Sumarto, Suryahadi and Bazzi 2008). The national economic action council of Malaysia, a consultative body that was formed to deal with the issues of the crisis played an important role I turning the economy around (Zubair 2003). There was a recovery plan that provided an opportunity for economic fundamentals. IMF played an important role in giving loans to the affected countries. The decision making on financial matters of the affected countries was taken by IMF until the countries were able to pay all the debts. Malaysia used the World Bank as an external resource rather than IMF. It monitored the restructuring of financial aspects that were very crucial at the time (Yu & Xu 2007. There were over speculation in real estate as well as huge public works monuments. The region experienced overhang debt and shrinking profits due to construction of cars, textile and electronics (Colin & Francis 2003). Immediate structural changes needed to be put into place so that the region so as to open these economies to wider disciplinary market forces which would promote the effectiveness and efficiency of foreign funds. Misallocation of resources needed to be dealt with for proper transparency, which increases efficiency in allocation of funds (Sumarto and Suryahadi 2005). Future suggestions As financial markets exist, crises are inevitable due to presence of boom and bust cycles, but the extent of the crises can be managed. Policies can be put into place by IMF to increase international reserves in the affected countries. This can be accompanied by financial sector reforms with sound supervisory procedures for banks to assess the risks (International Monetary Fund 2006). It is a mistake for a country to have a fixed exchange rate (Samuel 2003). It should be flexible enough to accommodate changes in the international financial markets. Sound macroeconomic policies need to be pursued in order to have a healthy banking system. There should be a strong reserve which can withstand an increase in interest rates. Capital liberalization is very important and must be taken with care. The affected countries had partial liberalization on short term capital inflows. The financial system was closed to competition from outside and was associated with structural rigidities meaning investment was done without due regard to risk. A more flexible financial system can minimize the implications of a crisis (Lee, and Changyong 2012). Creation of a sound environment in corporate and financial sectors when capital inflow resumes can help greatly in managing or preventing a crisis. A financial system should be programmed in such a way that it can channel capital into productive investment (Sumarto and Suryahadi 2005). Capital controls should be avoided to prevent future crisis. Foreign investors contribute significantly in capital inflows and it is very vital for a healthy financial system. Attraction of these investors should be paramount to any country preventing a financial crisis. Joining the free trade movement can attract more buyers of the country’s export and this in turn increases the foreign currency reserves, which can be spent in times of crisis (Sumarto, Suryahadi and Bazzi 2008). Good terms while exporting should be put into consideration as a country tries to win more buyers of its products and this can consequently improve the country’s current account. Prior to the crisis, there was low and inadequate supervision of Asian financial institutions. There was the close relationships between banks, corporations and the governments (Sumner and Wolcott 2009). These ties reduced competition as well open trade and investments causing misallocation of capital, which greatly translated to insolvency of the financial institutions something that would not have happened if there were competitive conditions (World Bank 2009). This means that there should be closer monitoring of any country’s financial institutions and a healthy competition among them to prevent this crisis. Conclusion A financial crisis is a situation characterized with some financial assets loosing value of dropping rapidly. This situation happened in Asia in the mid-1990s. Prior to the crisis, the affected countries were doing very well in terms of their strong economic base as fixed exchange rates. Suddenly, in 1997, they started experiencing low interest on foreign funds during recession. Their fixed rate exchange rates affected negatively as their export rate reduced significantly. There was panic among foreign lending institutions which made them to withdraw their credit translating to investors shifting their investment from the region. Domestic banks and private corporates had borrowed too much from external sources making it hard for their loan to perform. These factors contributed too much to the collapse of the affected countries’ currency and the crisis was triggered. The crisis had negative effects on internal and external financial markets. A good example was the US trade deficit, credit withdrawals as well as negative economic consequences on the affected countries. The international monetary fund’s reputation was negatively impacted to their failure to handle the situation beforehand. The crisis has taught us that good monetary and fiscal policies are very vital in handling such a situation. Countries are supposed to put into place better structural reforms to prevent such a situation. Well integrated trade with other countries help in providing foreign reserves that reduce such incidences. To prevent such situations from happening, countries should operate flexible exchange rates rather than fixed. In conclusion, there should be close monitoring of the banks, the private sector as well as governments to prevent such a crisis happening again in future. References Colin, B & Francis, L 2003, Malaysian economics and politics in the new century, Edward Elgar Publishing Limited, USA. International Monetary Fund 2006, Regional Economic Outlook—Asia and Pacific, pp. 33. International Monetary Fund 2009, Global Crisis: The Asian Context. Regional Economic Outlook — Asia and Pacific, pp. 52. Lee, H., and Changyong, R 2012, Lessons from the 1997 and the 2008 Crises in Korea. Asian Economic Policy Review, Vol, 7, no. 1, pp. 47–64. Noble, G and Ravenhill R 2000, “Cause and Consequences of the Asian Financial Crisis,” in Gregory W. Noble and John Ravenhill, eds., The Asian Financial Crisis and the Architecture of Global Finance, ed., Cambridge, England. Reinhart, C. M.., and Kenneth, S. R. 2011, From Financial Crash to Debt Crisis. American Economic Review, Vol.101, no. 5, pp. 1676–706. Samuel, C. 2001, Economic crisis in Malaysia: Causes, implications and Policy Prescription, Journal of Economic and Management, Vol. 9, No.2, pp. 204. Sumarto, S. and Suryahadi, A. 2005, ‘Principles and Approaches to Targeting with Reference to the Indonesian Social Safety Net’, Retrieved 5th Oct. 2016 from http://www.eaber.org/intranet/ Sumarto, S., Suryahadi, A. and Bazzi, S 2008, ‘Indonesia’s Social Protection during and after The Crisis’, in A. Barrientos and D. Hulme (eds) Social Protection for the Poor and Poorest, Palgrave Macmillan, Basingstoke. Sumner, A and Wolcott, S 2009, ‘What Are the Likely Poverty Impacts of the Current Crises?’, IDS In Focus Policy Briefing, Issue 07. Yu, T & Xu. D 2007, From crisis to recovery: East Asia rising, World Scientific Publishing Co. Pte. Ltd., Singapore. World Bank 2000, East Asia: Recovery and Beyond, World Bank, Washington, DC. World Bank 2007, East Asia Update: 10 Years after the Crisis, World Bank Washington, DC. Zakari, Z., Hussin, Z. Noordin, N. & Sawal, M. 2000, Financial Crisis of 1997/1998 in Malaysia: Causes, Impacts and Recovery Plans, Voice of Academia, Vol.5, No.1, pp. 75-96. Zubair, H 2003, Recent financial crisis in Malaysia: response, result, Challenges. Retrieved 5th Oct. 2016 from http://unpan1.un.org/intradoc/groups/public/documents/APCITY/UNPAN01976.pdf . Read More