On the 2nd of July 1997, Asia was hit by one of the most devastating financialcrises it has ever seen. Of all the financial crisis that have taken place, thiswas one of the most distressing in that it was totally unexpected. The purposeof this paper is to show that particular developmental strategies employed bythese economies eventually led to their downfall.
It will attempt to find outwhere the origins of the crisis lie, and what events started the cycle thateventuated with this disaster. In order to trace the events that led to theeventual collapse of the Asian economies, one must venture across the ocean tothe United States. The issue of liberalisation first gained attention in the USduring the Regan Administration. However, it was during the Clinton era thatliberalisation became a top priority.
Whereas previous governments had pushedfor the liberalisation of Japan, one of Clintons main foreign policyobjectives was the liberalisation of the Asian economies. This process waspushed forth in Asia with such vehemence because the region held a lot ofinvestment opportunities for American Banks, Brokerages, and other financialsector businesses. Unfortunately, Asias economies were not structurally readyto deal with the influx of capital that was headed their way. They had weakbanking and legal systems that were unable, or unwilling, to regulate the flowof foreign capital in the country. The Americans eventually persuaded Korea torelax its capital flow regulations by giving it the option of joining theOrganisation for Economic Co-operation and Development. Even then, Korea wasconcerned that its financial institutions may not be able to deal with an influxof foreign capital.
One fatal mistake that Korea, as well as other SoutheastAsian countries made, was that they opened their capital markets in the wrongway. They did not allow long term investments in Korean companies, but rather,only short-term investments that could be removed easily. One example of thesort of quick investments that were being made in Asia can be seen in theJapanese. In Japan the interest rates were very low, so investors would borrowat 2 percent and then convert their currency into Thai baht.
Due to the interestrate differential, they were able to make a lot of money off simple currencyconversion. Other Asian economies were quick to follow suit, and soon there wasa movement of huge amounts of capital into the region. In just one year, morethen $93 billion was invested in five Asian countries. One must, however,concede that Southeast Asia became very receptive to the changes being imposedon them by the United States. Eventually, foreign investment came to be seen asa miracle cure for underdevelopment. It was seen as a quick fix that could, in ashort period of time, bring countries to the same level of development as theWest. The trouble started in 1995, when the United States inflated the dollar,and hence also inflated the Thai baht and other Asian currencies that werepegged to the dollar.
This caused their exports to become expensive compared toChinese exports. The Thai deficit rose to such an extent that all their foreigncurrency reserves started to drain in order to pay it. This is the first timethat investors got to see the weakness in the Thai financial market. It is notpossible to place the entire blame for the crisis on the United States.
As wasmentioned before, Asian countries were more than happy to accept the capitalcoming there way. It is important to evaluate the different internal weaknessesin these economies that led to the eventual crisis. Enough stress can not beplaced on how the internal weaknesses of the Asian region led to this crisis.The remainder of this essay with deal with these weaknesses, and of the eventsthat eventually led to the collapse of the East Asian miracle. Liberalisation inSoutheast Asia took place primarily in two steps. In Thailand, and in much ofAsia, this liberalisation consisted of the removal of foreign exchange controls,interest rate restrictions, encouragement of nonbank (private) capital markets,and the adoption of the capital adequacy standard for bank supervision. Thisliberalisation led to intense competition in the Thai market.
Banks competed onthe size of their portfolios, and this led to some of the frivolous, short term,investment that became synonymous with the region. They also competed togenerate off-balance sheet transactions and quasi-banking operations, all ofwhich added to the vulnerability of the region. In Indonesia, as well, there wasa removal of banking regulations. With the removal of these regulations, thenumber of banks in the country more than doubled in a period of six years. Manyof these banks were owned by large industrial groups, which used them to managetheir own financial affairs. Banks also created Offsure accounts in order toconduct illegal activity.
This first liberalisation actually went a long way inreducing the reliability of banks. Investments were made without paying properheed to their long-term returns and the credit worthiness of the parties. Thiscombined with illegal activities made the banking system extremely susceptibleto any sort of external pressure. One example of this type of short sightedactivity can be seen in the expansion of bank portfolios to include a largenumber of property companies. Property companies would borrow from banks andthen float shares for the property in the stock market.
They money made in thisway would be enough to pay the banks and make a profit. The second phase of theliberalisation process consisted of openeing up the capital accounts of theregion. Guarantees were given to non-residents that they would be able towithdraw their investments and, also, the end of restrictions regarding foreignasset holding by residents. It is this phase that defined East Asian growth foralmost a decade. For the first time Thailands companies had access toexternal finance. This relationship between the corporations and the outsideworld also made this sector vulnerable to external changes. The level of capitalinflow in Asia reached monumental proportions due to another reason as well.
Before the liberalisation measures were implemented, these countries hadprovided incentives in the form of subsidies to foreign investors. Once theliberalisation was complete, these subsidies remained. This added an additionalincentive for foreign incentive. Besides this, the interest rate differentialbetween the developing and western countries was so great, local businesses hadan incentive to move towards foreign funding. In short, both the banking andcorporate sector became extremely dependent on foreign short-term debtliabilities.
Some Asian countries could see where this type of short-termspeculation was leading, but they were not willing (or unable) to imposeregulations on banks and investors. Malaysia was one country that was able toreduce the degree of short-term speculation through a combination of variousmeasure. At one point net inflows of capital actually went into the negative.Thai authorities, on the other hand, were unwilling to intervene to take controlof their current accounts deficit. They felt that it was inappropriate for agovernment to intervene on behalf of a deficit that was caused purely by theprivate sector. Similarly, in Indonesia also the current account deficit startedbecoming a representation of private investments.
Theories, like the oneexpressed by Cordon, imply that market forces will take care of any currentaccount deficit. However, in an unusual situation like this, where enormousamounts of capital is available for short-term profit, private agents do notalways behave rationally. These countries themselves provided investors withconditions that led to irrational behaviour.
The adoption of a fixed exchangerate and an absolute commitment to an unregulated capital account made for goodhunting. In these instances measures to keep the current account under controlare essential. Through this entire process, Thai governments were playing adelicate game trying to balance the exchange rate and the interest rate.
It wasimperative for these economies that the exchange rate should not appreciate.They engaged in sterilisation operations in order to keep the exchange rate atcertain level. However these activities caused interest rates to increase, whichagain caused more foreign capital to come into the countries. The East Asianeconomies, by the mid 90s were like a card house. Their foundation cards wereforeign investment and a fixed exchange rate. Foreign investment had providedall the funding for banks in their ill-conceived ventures. It was this moneythat allowed economies with very basic discrepancies to achieve such high growthrates.
The fixed exchange rate was necessary to keep foreign investment coming.In 1995 when the value of the Thai baht, and other East Asian currencies thatwere pegged to the dollar, increased in response to a corresponding increase inthe dollar, it set off a chain of events that ended with the destruction of theEast Asian economies. The inflation of the baht led to an increase in thecurrent account deficit.
Foreign currency reserves were exhausted in an attemptto pay for the deficit. This economic instability caused panic selling byinvestors. Thailand refused to devalue its currency, and in response interestrates went up in Thailand and in the Philippians. Under increasing pressure thatthe flight of capital created, the Thai government eventually let the baht floatfreely. In the open market the baht hit a record low of 28.
8 against the dollar.The Philippians also lets their currency, the peso, float semi-freely with theresult that it also ended at a record low of 32.38 against the dollar.
As theeffects of this currency devaluation swept throughout Southeast Asia, there wasa multilateral currency meltdown. Dozens of financial firms in the region wereclosed and their operations came under scrutiny. Banks stopped extendingshort-term loans due to a dry up of capital and business, unable to pay back,went bankrupt. Essentially what happened is that faced with the prospect ofeconomic instability in the region investors started selling their stakes inthese economies. As the money dried up, the entire system that had developedaround this money also crumbled. When an economy is built on such delicatecards, even a slight change in any one factor (in this case the exchange rate)and lead to a catastrophe. What is interesting is that even though all areas ofAsia (in fact the entire world) were hit by the crisis, certain countriesweathered the crisis better.
Singapore and the Philippines, who had exercisedcome capital control and had placed prudential regulations on their banks, wereable to recover from the crisis much faster. In fact, that they were even hit bythe crisis is due more to the non-availability of financial information in theregion than anything else. The crisis caused general selling by investors in theentire region who did not have time to differentiate between the various amountof economic distress in the region. Essentially, it was due to some level ofContagion. As you can see, a variety of factors went into the destruction of theSoutheast Asian economies. The Americans failed to realise that under theconditions that existed in the region, uncontrolled capital liberalisation wouldnot work. The influx of capital overwhelmed societies, which were not equippedwith the knowledge to deal with it.
The entire system was dependent on adelicate balance between exchange rates and other monetary factors. In the endthe over liberalisation of these economies, without sufficient controls led toone of the most dramatic crisis of all time. In response one can not help butwonder if capital mobility is more a need of the west than of the east.
Underdeveloped countries need time to develop the institutional framework tohandle this new form of Globalisation. Until then, they can not be fullyintegrated into the world capital market.Politics