Competing Theories of the Asian Financial Crisis - Essay Example

Competing Theories of the Causes of Asian Financial Crisis Introduction There have been a number of studies on the Asian financial crisis analyzing the causes of the crises and most of them agree on some broad reasons. Asian economies grew dramatically during the early and mid 1990s. Starting from the year 1997, the Asian economies were affected badly due to the sudden collapse of the East Asian currencies and the economies were subjected to a wide spread recession. There are no studies that can precisely determine the starting and ending time frame of the Asian financial crisis and the particular reasons for such sudden overturn of the economies. One of the theories established by Corsetti et al (1999) attribute the contagion effect in the Asian economies implying that the economies geographically located adjacent to each other normally follow the other countries in the region for the rise and fall in their economies. Alon and Kellerman (1999) substantiate this theory in that they state that the crisis was a reminiscent of the ‘Domino Theory’ of 1960’s. There are other view points attributing different reasons for the financial crisis in Asian economies. This paper analyzes the competing theories that examine the causes of the Asian financial crisis in the light of several theoretical models established by research studies on the crisis and its causes. Evolution of the Crisis Before discussing the causes and effects of the Asian financial crisis, it is important to study the background for the evolution of the financial crisis in the Asian economies. The default of a large amount of debts by Hanob Steel Corporation of South Korea started off the financial crisis in the region. This default by the steel major was followed by many business failures in the country. (Amitava Chatterji 2003) Following this there was an uneasy feeling for the speculators about the economic and political developments in the region. Hence in May 1997 they initiated heavy capital outflows from Thailand putting the baht – the currency of Thailand under pressure. Though there were assurances from the Thai government that there would be no devaluation of baht, Bank of Thailand in July 1997 announced the free float of baht which virtually devalued the currency by 20 percent. (Amitava Chatterji 2003) This had triggered the suspicion in the minds of the investors on the Asian regional capital and currency markets and the investor confidence suffered a marked deterioration. Following the act of Thailand, countries like Philippines, Malaysia, and Singapore allowed free float of their respective currencies and the values of all the currencies took a slump. In the mid of August 1997 Indonesia also followed suit and its currency took a downward plunge. (Amitava Chatterji 2003) The Hong Kong stock market suffered a heavy loss of nearly 25 percent of the value of the stocks during a three day business in the month of October 1997. South Korea had no other alternative except to allow its currency also be allowed to float and in mid-November, the country allowed the currency won to float freely which faced a sharp drop in its value. All the economies as a result of the devaluation had to face a heavy recession as an aftermath of the crisis. (Amitava Chatterji 2003) This has necessitated the intervention of International Monetary Fund (IMF) to chalk out bail out plans in the form of cash and credit monetary assistance for the affected countries with the assistance of the World Bank and the Asian Development Bank. (Amitava Chatterji 2003) Fundamental Reasons for the Crisis Several reasons are being found and discussed by various scholars and authors for the financial crisis in the Asian region. However all of them agree on the following basic reasons which may be considered as the root cause for the financial crisis in the Asian region. (1) The countries had resorted to excessive borrowings in foreign funds on a short-term basis. These funds were utilized by the countries in offering excessive long-term lending domestically with the result the countries did not find enough resources to meet the repayment obligations on the foreign loan maturities. According to Yeh, Suwanakul, and Chun (1999), the lenders in the international markets normally do not advance loans for projects having a long-term repayment tenor. Hence most of the loans obtained by the countries were of short term nature maturing in a year or so. However the regional banks utilized these funds to advance long term loans for building up manufacturing capacity and infrastructural facilities in the country. Thus the regional banks could not maintain a perfect match between the borrowing and lending and there was lack of monitoring on the part of the international lenders also. (2) The financial structures of the economies were so weak that the banks had very poor risk management systems. In addition there was no effective supervision from the government agencies or authorities to take remedial action at the appropriate time. The Asian regional Banks had poor assessment of the credit-worthiness of the borrowers. Yeh, Suwanakul, and Chun (1999) observe that the loans were granted on the basis of the personal relation ship and on the basis of the collateral securities rather than a structured credit analysis. Sarno and Taylor (1999) note that when the bubbles burst the value of the collateral securities did not even match the amount of the loans. Due to the ownership of the banks by the government and the excessive influence of the government the terms of the domestic loans were extended which affected the banks’ liquidity to meet the short term obligations. (Barth et al 1998) (3) The presence of moral hazard and the intervention of the governments in lending by the banks also had resulted in the triggering of the crisis. The moral hazard is defined as the “Perception of guarantees for financial institutions by governments and/or guarantees for national economies by international agencies such as the IMF and the World Bank” (Amitava Chatterji, 2003) Chen (1999) is of the view that due to the increased presence of moral hazard there had been a huge inflow of foreign capital in to the Asian countries without the guarantees either implicit or explicit by the respective governments or other agencies. This has made the rate of interest on the foreign and domestic loans equal and hence there was no incentive to borrow more foreign funds for long-term projects. Role of External Factors in the Asian Financial Crisis Apart from the actions of the countries and their internal financial systems there were several other external factors that led to the financial crisis in the Asian economies. Some of these factors are: (1) Following the economic recession of the 1990s the lower interest rates in Japan has resulted in heavy capital outflows for catering to the large investment projects in the South East Asian countries (Amitava Chatterji 2003). (2) There is a comment from some of the scholars that the devaluation of the Chinese Yuan up to 50 percent in the year 1994 had affected the cost competitiveness of the products from the Asian countries. However this argument is disputed by several other authors like Fernald et al (1998) who point out that much of the transactions had been carried out after China had effected the devaluation. (3) The financial deregulation measures undertaken by the Asian economies had attracted the major foreign banks to make heavy investments in the Asian region. As pointed out by Krugman (1998) the confidence of the international investors that the loans advanced in these countries are guaranteed by the respective governments or IMF had inadvertently contributed to an excessive lending which ultimately led to the crisis. (4) The consumption tax imposed by Japan in April 1997 had resulted in a large scale reduction of consumer expenditure and this has severely hit the exports from the Asian countries. This tax also delayed the economic recovery of Japan (Amitava Chatterji 2003). (5) From the mid of the year 1995, there had been a sharp increase in the value of US dollar as against the Japanese and European currencies. Since the Asian economies had pegged their currencies with the US dollar, the increase in the dollar value has seriously affected the competitiveness of the Asian countries (Amitava Chatterji 2003). Role of the Financial Systems in the Asian Countries It may be noted that the Asian financial crisis had been fuelled by a combination of fundamental reasons and the external factors discussed above. These factors had made the economies vulnerable to changes in market sentiments. In addition there had been a close association between the capital flows as shown in the following table and the role of the financial sector in the respective countries in expanding the domestic credit for the acquisition of real estate and property which also triggered the downfall of the economies. Table: International Bank and Securities Financing of 5 Asian Economies ($ Billions) Average Q1 + Q2 Q3 Q4 Q1 + Q2 Q3 Q4 Year 1990-95 1996 1997 1997 1997 1998 1998 1998 28 56 49 -39 -96 -96 -59 -43 Note: The 5 countries are Indonesia, Korea, Malaysia, Philippines, and Thailand. Source: Pilbeam (2001) The East Asian Financial Crisis: Getting to the Heart of the Disease Managerial Finance Vol. 27 Number 1/2 The table clearly indicates the high net capital inflow into the Asian economies till the first and second quarters of 1997 when the trend of the cash flows took a sudden and dramatic trend due to the crisis for which the financial systems present in the countries had to take a part of the blame. Hence it becomes critical to analyze the part played by the financial sector in these countries in causing the crisis. The part played by the banking system in the Asian financial crisis has been the subject matter of several studies including by Kaminsky and Reinhart (1997) and Goldfajn and Rodrigo (1997). The main flaw with the financial and banking system in the East Asian economies take the root from the pressure of their respective governments on the domestic banks to lend to larger corporations on longer terms. The governments also forced the corporations to undertake heavy infrastructural investment programmes to achieve a faster economic growth. The governments also provided subsidies, tax concessions, and public guarantees covering such investments. Moreover the governments also encouraged the state-run banks to advance loans to these corporations without a proper assessment of the risk-return criteria. All these reasons have resulted in the failure of the banking system to meet their obligations on the maturities of the short term debts due. Economic Models of the Asian Financial Crisis The occurrence of the financial crises has been explained by several economic models. For instance Krugman (1979) states in an exchange system which is fixed, the financial crisis can be caused by weak macroeconomic policies. In particular the monetization of the fiscal policies will necessarily force the authorities to go in for faster expansion of domestic credit. Blanchard and Watson (1982) advocate the rational financial bubbles in which there is a continuous acquisition of overvalued financial assets in the hope that the continued upward trend will compensate the risk of a sudden downward trend. However, an eventual collapse is inevitable which results in heavy capital losses to those who are caught on the top of the bubble. Akerlof and Romer (1994) emphasise the role of moral hazard whereby the existence of explicit or implicit public guarantees leads under-capitalized banks to engage in excessively risky lending and even outright fraud. In these cases where there is an economic shock the banks will find themselves with increased non-performing assets that will result in an obvious financial crisis. Sachs (1995) observes the economic model of disorderly workout in any financial crisis. A disorderly workout results because of the lack of coordination among the creditors. In situations which appear to be heading towards a crisis the individual creditor decides to withdraw his funds from the already distressed borrower. Similarly there may be lack of coordination among the borrowers due to absence of or ineffective bankruptcy laws. The Financial Crisis and the Impact on the Economy of Taiwan By using the accumulated foreign exchange reserves and by adopting suitable economic policies, Taiwan was able to minimize the impact of the financial crisis on its economy. In fact the impact of the financial crisis on the Taiwanese economy was less severe as compared to other economies in the region. This is evident from the fact that while the other countries lost almost 50 percent of the value of their currencies during the 18 month period from early 1977, the New Taiwanese Dollar lost only 20 percent during the same period. (Business America 1998) By the end of the year 1998 the country reported an economic growth of 4 to 5 percent the fifth highest reported economic growth although there had been a fall in the value of its exports by 9 percent during 1998. (Anderson, 1998) In order to reverse the harsh effects of the financial crisis Taiwan took several steps that were considered important and appropriate in the wake of the financial crisis. Some of these steps are: Stable Currency The country maintained the NT dollar as a restricted currency and the overseas financial institutions can not trade in the currency. By the opening of a new foreign exchange market in Taipei in the year 1989 the Central Bank of Taiwan made the value of the NT dollar to be decided on the basis of the market forces of demand and supply. Thus Taiwan’s conservative approach in managing its financial affairs had been instrumental in maintaining the stability of its economy. Taiwan identified the need for a strong current account, excess foreign reserves, and an absolute resistance to speculative pressures for preventing the depreciation to its currency. The country focused on these areas to tackle the adverse impact of the financial crisis (Business America). Increased Competitive Position in the Hi-tech Industry Considered to be the Silicon Valley of the Far East Taiwan had utilized the financial crisis to reaffirm its leadership position in both hardware and software markets of the computer industry. Even at a time when the electronic industry of the Far East was facing its downward trend for the third consecutive year, the electronic industry in Taiwan was expanding and the Asian Financial crisis could not contain growth. (Mark Caroll, 1998) Enhancement in the Manufacturing Value Taiwan identifying the high cost of land and labor had moved substantial number of businesses to offshore by way of outsourcing. Offshore manufacturing had enabled Taiwanese companies larger and have invested around $ 80 billion around the world and the businesses are looked after by more than 300,000 Taiwanese expatriates. In order to enhance the value of its production chains, Taiwanese companies import finished and semi-finished parts and components from the other South East Asian countries. This in fact helped Taiwan to use the low cost labor and products most during the time of financial crisis due to devaluation of currencies in those countries (Business America). Diversification of Portfolio of Countries In order to promote a healthy business traffic Taiwan’s Board of Foreign Trade had invited prospective investors and about 58 teams from different countries like Japan, Australia, Egypt, United States, Central America, and North Africa visited the country during the year 1999. A reflection of this could be found in the increase of private-sector investment of 14 percent in the year 1998. This shows that despite the economic crisis the country remained an attractive investment destination for overseas investors. Stimulation of Domestic Demand The announcement of 134 new public projects, with an estimated capital outlay of NT $ 1 trillion and NT $ 194 billion for various infrastructural facilities like transportation and other improvements (Engbarth, 1998; Ritt, 1998; East Asian Executive Reports, 1998) have proved a sound decision to stimulate the domestic demand and reverse the impact of the financial crisis. Liberalization of Financial Institutions and Regulations Hoover (1998) remarks “Compared to its South East Asian counterparts, Taiwan has a more mature, competitive, and open economic system, which has helped insulate the country from the Asian economic crisis”. But still as per the Western standards the economy has much more to opportunities to offer so that there will be a uniform growth in the economy. This triggered the economic reforms undertaken by the country in the form of banking reforms and also the country has implemented several legislations to bring the country closer to WTO membership. Conclusion Thus the Asian financial crisis is the result of several internal factors that are common to the Asian economies in that the financial systems of these countries could not gear up themselves to meet the foreign loans on maturities. In addition there are several other external factors that also contributed to fuel the economic crisis. Despite the devastating effect of the financial crisis on the economic front Taiwan was able to overcome the adverse impact of the finance References Akerlof and Romer (1994) Looting the economic underworld of bankruptcy for profit, National Bureau of Economic Research, Working Paper No 1869. Alon, I., and Kellerman, E. A. (1999), “Internal Antecedents to the 1997 Asian Economic Crisis” Multinational Business Review, Fall pp. 1-12. 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