Asian economic crisis: the initial stages of the crisis and the major causes of it - Essay Example

Asian Economic Crisis Introduction Economies of East Asia have had good economic performance after the 2nd World War.They have had a high savings rate and generally prudent fiscal policies. In the decade before 1997, these led to enormous capital flow to this region a realistic probability of the weaknesses and infancy of their economies. In 1998, it was evident that the global economy was going under recession with a reduction in global trade by about two-thirds. This trend was initiated by the Asian Economic Crisis which directly affected, Indonesia Korea, Singapore, the Hong Kong Special Administrative Region (SAR), Thailand, Malaysia, Taiwan and the Philippines. The crisis was caused by some factors which have been of great speculation by scholars. The crisis began in 1996 when there were initial triggers to the crisis and ended in 1998 after some policy changes largely associated by IMF’s intervention. The following paper analyses the initial stages of the crisis and the major causes of it. It also captures some of the policies put in place to counter the effects of the crisis and bring back the economies into their initial performance. History Early stages of the Crisis A. Speculation by Participants in the Currency Markets Excessive Speculation in the currency markets began in Thailand. Speculation acts as a discipline to a government’s policy (University of Hong Kong, 5-8). According to the IMF, speculation in the currency markets had its share in triggering the Asian economic crisis. Financial institutions, investment banks and hedge funds acted together with domestic investors in taking short positions against the baht. The baht was perceived to provide a one-way bet given the fixed exchange rate and low cost of funds. B. Contagion in Asian Economies With the developments in the financial, market in Thailand, there arose spillover effects to other financial markets around Thailand. Investors began to realize similar symptoms in surrounding economies since financial markets are prone to over reactions to underlying variables, investors re-assessed they risk factors and began to take actions in a bid to mitigate effects of such happenings as those in Thailand. The spillover effects in South East Asia were unprecedented. Initial contagion was from Thailand to Indonesia. The other countries followed. It is argued that investors in Malaysia and the Philippines had irrational reactions since they acted to reflect that they grouped South East Asia countries alike without detecting the differentials in these economies (University of Hong Kong, 6-7). Underlying Causes of the Crisis The following topic looks into several structural weaknesses in the economies of South East Asia. These are: current account deficit, over-inflated asset prices, excess lending, corruption and macroeconomic policy mistakes. A. International Capital Flow and Excessive Monetary Growth Asia’s fast economic development in the 90’s coincided with and was attributed to capital flows to emerging markets during that period. The following table shows the Net Private Capital Flows to East Asia between 1994 to 1996 adapted from World Bank Global Development Finance, 1998. Source: International Financial Statistics, January and December 1999, IMF, Instead of letting their currencies to appreciate, some countries which operated a managed or a pegged exchange rate system like Thailand and Malaysia formed domestic liquidity to absorb the effects of the increasing large capital inflows. These led to unsustainable monetary growth. Credit and money growth rates shot to about 30% annually. This was one of the major mistakes of the East Asia economies that led to problematic shock that caused the economic and financial crisis of Asia (IMF, 56). B. Weaknesses in the Economies Susceptibility of Asian countries to the crisis was heightened by several structural weaknesses in their economies that were aggravated by massive capital inflow and excessive monetary growth in the region. 1) Moral Hazard, and Reliance on Short-Term Foreign Debt Majority of the capital inflows to Asia was as a result of shorter bank debts. Asia absorbed nearly 60% of all short-term international capital flows. According to The University of Hong Kong (p. 44), “The effective peg of most Asian currencies to the U.S. dollar over an extended period created a problem of moral hazard and prompted short-term and often unhedged borrowings among domestic institutions.” the problem of moral hazard also arouse from the fact that borrowing was encouraged if it was inform of US dollars. High weighting of short-term foreign bank within made the Asian economies made them susceptible to sudden reversals. Ratio of short-term foreign debt to foreign-currency reserves was 1.5 in Thailand, 1.7 in Indonesia, and 2.1 in Korea. This was in 1997 when most of other developing countries had ratios of below 0.6 (University of Hong Kong, 37). . 2) Financial-Sector Liberalization, and Inadequate Regulation Large amounts of the international capital flows were channeled into the banking systems of the Asian economies. Financial institutions borrowed heavily in foreign currencies. Though their some reforms aimed at managing the rapid economic growth, there are some regulatory and supervisory areas which did not meet international standards. These include: Inadequate disclosure Requirements, loose asset classification systems and provisioning rules for possible losses, weak legal lending limits on single borrowers or borrowing groups and low capital-adequacy ratios. The financial system was weak. Most of the borrowing was evaluated on basis of collateral rather than the expected and present cash flows of businesses. There were influence by government and the political system of these countries on provision of loan and the amounts. Some countries which tried to liberalize their financial markets made them susceptible to international markets instabilities that made them even more vulnerable. Poor supervision and regulation of the financial system, high external exposer and lack of discipline in the market led to an effect of heightened susceptibility to recessions and instabilities in capital markets (Clara & Iliana, 15). 3) High Corporate Leverage and Protectionism In Thailand and Malaysia, Leverage doubled and increased by one-third in Korea in the early 90’s. This created some form of weaknesses in the corporate sector (IMF, 46).. Profitability was however declining. This meant that these companies could not meet their obligations to lending institutions especially because most of the debt was short-term. A debt crisis resulted from this situation. Source: International Financial Statistics, January and December 1999, IMF, Increase in leverage ratios was one of the strategies of the governments of South East Asia in an attempt to increase economic growth. The government provided credit facilities, subsidized loans, and tax breaks to exporters. Protectionism encouraged lack of market discipline especially in the credit market. Banks suffered from governments involvement through pressure that priory sectors be lent. Pension and provident funds which are Sources of long-term debt were underdeveloped. Governments limited the ability of foreign bank to implement international standards of credit evaluation and corporate governance. Transparency in the financial system and corporate governance was overlooked in South East Asia economies especially in sectors termed and priority sectors (IMF, 56). These factors lead to the Asian economic crisis or made the economies of this region prone to any financial or economic crisis or shock. C. Adverse External Developments Besides the structural weaknesses and excessive monetary growth, Asian Economies faced external problems. These can be categorized into two; deteriorating terms of trade and the recession of the Japanese economy. 1) Deteriorating Terms of Trade & Current Account Deficits Trade has played an important role in the growth and development of East Asia in general. Trade as a ratio of GDP grew from 15% to 50% between 1970 and 1995. AS the year 1995 came to an end, trade and thus growth began to slow down for the following reasons; there was a fall in the general world growth, Appreciation of the US dollar in relation to the yen, real effective exchange-rate appreciation, and fall of export prices and Devaluation of the Yuan (University of Hong Kong, 49). These factors had an end result of reduced imports and increase of current accounts deficits in the Asian economies. 2) Japan’s Role Japan was the major source of funds for the leading growth sectors of the Asian economies and their export destinations. Its recession and slow economic growth played an important part in the Asian economic crisis. Japan was a provider of capital to the East Asia countries. This was in form of both loans and foreign direct investments. Their banks major sources of credit to East Asia economies and with the slow economic performance, credit to this region was cut. Japan’s foreign direct investments were also reducing because of is reducing GDP. Japan also provided key export market to goods from South East Asia. Demand for this good reduced with the slow performance of their economy leading low demand of exports form South East Asia. The Asset Bubble and its Aftermath also contributed to the causes of the Asian economic downturn. The 80’s were characterized by rapid increase in asset prices (especially stocks and land prices). The first half of the 90’s was notably characterized by a sharp fall in these prices. According to the Hong Kong University (p. 61), “During this period, the Nikkei 225 Index rose from under 15,000 to over 35,000 and dropped back to around 15,000. The Japan Real Estate Institute’s land price index rose from about 40 to 100 in 1990 and then dropped back down to about 50… These negative developments adversely affected the Asian countries. Exports to Japan slowed as its economy slid into recession. At the same time, Japanese banks, besieged by problems in their domestic market, started to withdraw capital from Asia, thus depriving the region of a major source of funds.” D. Instability in Capital Markets Instability in the capital markets has been explained by two major phenomena. First are the unprecedented Shifts in Market Expectations and Confidence. Many of the lenders and investors in the Asian economies went into these economies without having carried out sufficient research. They channeled their funds in to these countries only with the reason that these countries were experiencing rapid economic growth. The positive confidence and expectations built was dome without due diligence (Luk, 20). Most of the economies which invested into Asia’s emerging markets operated within the degrees of the “Anglo-Saxon model”. When problems in some banks and corporations arose, these investors came to learn that this model was quite different to one which worked in South East Asia. This led to panic due to the sudden reduced ratings of these economies. Funds were transferred in huge quantities form these regions. Many credit rating agencies dropped their expectations in these regions. The result was a massive transfer of fund since these are had now become high risk areas. This led to weakening of the base of these economies and hence the cause to the Asian economic crisis. Globalization of Financial Institutions, and Advances in Financial Products was also a contributing factor. Banks and other financial institutions in East Asia could borrow fund in dollars or yen (Goldstein, 25). These were more affordable since local currency borrowing was tagged to high rates intended to contain inflation in these regions. Use of excessive leverage in international borrowing led to participants taking even larger positions than they normally could with their own funds, thus further magnifying movements in the market. Cross-currency “carry trade” which began in 1991 and other technological advances led to fast movement of fund. This led to creation of possibility of massive disruption of markets due to instantaneous transfers (Clara & Iliana, 08). With this technology, investors were now able to transfer fund instantaneously out of Asia with its increasing risks. These factors caused Asian economies to be more prone to shocks in their economy and demand fluctuations. Transition of the crisis and Major Economic Setback Effects of the crisis A. Fall of Equity Markets Equity Markets reflect the general health of an economy. During the Asian crisis, the 8 Asian countries experienced a sharp drop in their equity markets. This reflected reduced expectation of profits by the investors. Since some of these countries’ governments could also not meet obligations to foreign debt, there was massive shift to safe heavens which exacerbated the anticipated problems. B. Competitive Currency Devaluations Asian economic crisis was also characterized by rapid fall in value of their currencies against the dollar. Since devaluations can be contagious, its effects move from country to country (Luk, 25). This is because when a competing country’s depreciation leads to appreciation which leads slower economic performance. This necessitates a depreciating and hence depreciation is transferred from country to country. This is the phenomenon that faced East Asia economies. C. Interest Rates With the flight of funds to better overseas markets, there was an increase in interest rates. This is because there were limited amount of fund available for lending. The credit crunch could also be attributed to the risky nature of investments in these economies (Goldstein, 55). The reduced profitability and under-performing economies lead to an increase in cost of funds in order for financial institutions to factor in increase risks. D. The Real Economy The economies of South East Asia experienced severe contractions. There were increases levels of corporate bankruptcies and unemployment levels shot up. In the first half of 1998, GDP contracted by approximately 12% in Indonesia, by 8% in Thailand and by 5% in Malaysia and the Philippines (Goldstein, 67). Even though devaluations were expected to yield growth, in crisis situations such as these, devaluation leads to contraction in economic activities and deflation. Since Asian economies accounted for almost a third of each other’s exports, devaluation measures did not increase output. Reliance on intermediate inputs imported from other countries was affected since the import sector was negatively affected by devaluations. Selected Asian Economies: Bilateral US Dollar Exchange Rates and Equity Prices Source: International Banking and Financial Market Developments — BIS Quarterly Review, June, 1998, November, 1998, June, 1999. Policy The IMF and its Handling of the Asian Crisis The IMF was able to inject liquidity to these economies in a bid to stabilize them. A. Financial Assistance IMF provided funds to South East Asia economies to prevent sovereign default. It provided approximately $112 as rescue packages for Indonesia, Malaysia and Thailand (Clara & Iliana, 11). Some sources of these funds were the World Bank and the Asian development bank. Source: "Asian Meltdown", The Banker, December 1997 p.43 B. The Austerity Programme IMF formulated agreements regarding policy changes in these economies. These include setting of permissible sizes of budget sizes and more strict more monetary policies. Fiscal policies were tightened to limit the amount of international flows of funds to these countries. Thailand was instructed to reduce its budget deficit by cutting its social expenditure. These funds were diverted to bank restructuring. IMF imposed cuts equivalent to about 1% of GDP in Indonesia and creation of budget surplus of 1% of GDP per annum. Monetary policies were also agreed upon. High interest rates policies were imposed on these countries to reducing the need for external capital inflows and ensure export competitiveness was upheld. Without strict monetary policies, effects of devaluations are not experienced. C. Restructuring The structural weaknesses of these economies needed to be addressed. The IMF ensure that adjustment polices were put in place. IMF demanded that unviable financial institutions be closed down with associated write down of shareholders capital. IMF arranged for funding of undercapitalized institutions in the Asian economies. It also ensures that there was foreign participation in management of domestic financial systems and that weak institutions were closed monitored (Clara & Iliana, 19). Implications for future growth Majority of the Asian countries were affected by the crisis. With the policies put in place by the IMF, these countries had begun recovering in 1999. IMF provided estimates of GDP performance which are summaries below: Export growth Growth of exports was anticipated. However, this was not experienced immediately after the crisis. Korea’s exports dropped to 4.9%, whilst those of Thailand, Malaysia and Indonesia were dropped to approximately 6.8%, 6.9% and 10.5%, respectively. This was as a result of poor trade structures in these countries and over reliance amongst themselves as destinations of their exports. In 1999, these over reliance led to improvements in these economies due to the overall increase in global trade by about 5%. In 1999, export growth reached 12% for Korea and 13% for Malaysia. Implications for the PRC China showed attribute of many problem of South East Asia. It was able to avoid many impacts of the crisis and maintain a positive economic growth. The government strict control over their capital account restricted inflows of capital into china(University of Hong Kong, 95-97). This help it avoid the sudden exit of international funds which face south East Asian countries and therefore, China shielded itself form the crisis (Wong and Sonia, 16). Source: International Financial Statistics, January and December 1999, IMF. Conclusion Asian financial crisis developed rapidly into a complete financial and economic crisis from mere initial speculations of currencies. Currency speculations in Thailand were followed by Contagion in Asian Economies which was another occurrence in the early stages of the crisis. One of the major causes of the crisis was the International Capital Flow which flooded the financial markets of these regions. Excessive Monetary Growth was being experienced characterized by credit and money growth rates of nearly 30% yearly. Structural weakness in these economies portrayed by short-terms foreign debt, protectionism and lacks of financial market discipline aggravated the effect of massive capital inflow and excessive monetary growth. There were adverse external developments that led to Deteriorating Terms of Trade and Current Account Deficits. These external developments were aggravated by the poor performance of Japan which was a provider for capital and market of these regions output. Investors in the region developed unprecedented negative expectations in the region, paralyzing its capital markets and causing flight of funds into other international financial markets. All these factors occurred in a relatively short period of about one year, resulting to the occurrence of the Asian Economic Crisis. Some of the effects of the crisis include a Fall of Equity Markets, by rapid fall in value of their currencies against the dollar, soaring in interest rates and severe contractions in the real economies of the region. These effect needed corrections and, hence, IMF step in by offering financial assistance, formulating agreements regarding policy changes and addressing structural weaknesses through restructuring of various sectors. China was also affected by the crisis since its double digit growth rate in that decade was reducing to one digit. It, however, mitigated these effects by government strict control over their capital account restricting inflows of capital into China. Policy implications for future growth included a prediction by IMF of positive economic growth rates which were experience after some initial problems attributed to poor trade structures in the region. This paper has investigated the initial stages of the crisis and the major causes of it. It has also captured some of the policies put in place to return South East Asia’s economies into their initial performance and reduce the effects of the crisis. Works Cited Garcia, Clara and Iliana Olivie. "The Financial Crises in South-east Asia", ICEI Working Papers, No. 11 (part IV), Complutense University of Madrid, October 1998 – 22. Print. Goldstein, M. “Early Warning Indicators of Currency and Banking Crises in Merging Economies”, Financial Crises and Asia, March 1998. Print. International Financial Statistics, January Issue, IMF, East Asia Quarterly Brief, World Bank, Jan. 31, 2000. Print. IMF “Asian Meltdown”, the Banker, December 1997. Print. Luk, Y.F. “Non-Exchange Rate Adjustments in the Asian Crisis: The People’s Republic of China and Hong Kong”, Seoul Journal of Economics: 11, No. 4, 1–29. 1998. Print. The University of Hong Kong. Asian Financial Crisis: Causes and Development. Hong Kong: Hong Kong Institute of Economics, 2010. Print. Wong, Richard and Sonia Wong. “Removing Regulatory Barriers in China: Changing the Foreign Exchange Regime.” The University of Hong Kong Paper prepared for the Conference of China as a Global Economic Power: Market Reforms in the New Millennium, Hong Kong, 15–18 June, 1997. Print. Read More