South East Asian Crisis Essay Research Paper

On the 2nd of July 1997, Asia was hit by one of the most devastating financial crises it has ever seen. Of all the financial crisis that have taken place, this was one of the most distressing in that it was totally unexpected. The purpose of this paper is to show that particular developmental strategies employed by these economies eventually led to their downfall. It will attempt to find out where the origins of the crisis lie, and what events started the cycle that eventuated with this disaster. In order to trace the events that led to the eventual collapse of the Asian economies, one must venture across the ocean to the United States. The issue of liberalisation first gained attention in the US during the Regan Administration. However, it was during the Clinton era that liberalisation became a top priority. Whereas previous governments had pushed for the liberalisation of Japan, one of Clinton?s main foreign policy objectives was the liberalisation of the Asian economies. This process was pushed forth in Asia with such vehemence because the region held a lot of investment opportunities for American Banks, Brokerages, and other financial sector businesses. Unfortunately, Asia?s economies were not structurally ready to deal with the influx of capital that was headed their way. They had weak banking and legal systems that were unable, or unwilling, to regulate the flow of foreign capital in the country. The Americans eventually persuaded Korea to relax its capital flow regulations by giving it the option of joining the Organisation for Economic Co-operation and Development. Even then, Korea was concerned that its financial institutions may not be able to deal with an influx of foreign capital. One fatal mistake that Korea, as well as other Southeast Asian countries made, was that they opened their capital markets in the wrong way. They did not allow long term investments in Korean companies, but rather, only short-term investments that could be removed easily. One example of the sort of quick investments that were being made in Asia can be seen in the Japanese. In Japan the interest rates were very low, so investors would borrow at 2 percent and then convert their currency into Thai baht. Due to the interest rate differential, they were able to make a lot of money off simple currency conversion. Other Asian economies were quick to follow suit, and soon there was a movement of huge amounts of capital into the region. In just one year, more then $93 billion was invested in five Asian countries. One must, however, concede that Southeast Asia became very receptive to the changes being imposed on them by the United States. Eventually, foreign investment came to be seen as a miracle cure for underdevelopment. It was seen as a quick fix that could, in a short period of time, bring countries to the same level of development as the West. The trouble started in 1995, when the United States inflated the dollar, and hence also inflated the Thai baht and other Asian currencies that were pegged to the dollar. This caused their exports to become expensive compared to Chinese exports. The Thai deficit rose to such an extent that all their foreign currency reserves started to drain in order to pay it. This is the first time that investors got to see the weakness in the Thai financial market. It is not possible to place the entire blame for the crisis on the United States. As was mentioned before, Asian countries were more than happy to accept the capital coming there way. It is important to evaluate the different internal weaknesses in these economies that led to the eventual crisis. Enough stress can not be placed 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 events that eventually led to the collapse of the East Asian miracle. Liberalisation in Southeast Asia took place primarily in two steps. In Thailand, and in much of Asia, 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. This liberalisation led to intense competition in the Thai market. Banks competed on the size of their portfolios, and this led to some of the frivolous, short term, investment that became synonymous with the region. They also competed to generate off-balance sheet transactions and quasi-banking operations, all of which added to the vulnerability of the region. In Indonesia, as well, there was a removal of banking regulations. With the removal of these regulations, the number of banks in the country more than doubled in a period of six years. Many of these banks were owned by large industrial groups, which used them to manage their own financial affairs. Banks also created Offsure accounts in order to conduct illegal activity. This first liberalisation actually went a long way in reducing the reliability of banks. Investments were made without paying proper heed to their long-term returns and the credit worthiness of the parties. This combined with illegal activities made the banking system extremely susceptible to any sort of external pressure. One example of this type of short sighted activity can be seen in the expansion of bank portfolios to include a large number of property companies. Property companies would borrow from banks and then float shares for the property in the stock market. They money made in this way would be enough to pay the banks and make a profit. The second phase of the liberalisation process consisted of openeing up the capital accounts of the region. Guarantees were given to non-residents that they would be able to withdraw their investments and, also, the end of restrictions regarding foreign asset holding by residents. It is this phase that defined East Asian growth for almost a decade. For the first time Thailand?s companies had access to external finance. This relationship between the corporations and the outside world also made this sector vulnerable to external changes. The level of capital inflow in Asia reached monumental proportions due to another reason as well. Before the liberalisation measures were implemented, these countries had provided incentives in the form of subsidies to foreign investors. Once the liberalisation was complete, these subsidies remained. This added an additional incentive for foreign incentive. Besides this, the interest rate differential between the developing and western countries was so great, local businesses had an incentive to move towards foreign funding. In short, both the banking and corporate sector became extremely dependent on foreign short-term debt liabilities. Some Asian countries could see where this type of short-term speculation was leading, but they were not willing (or unable) to impose regulations on banks and investors. Malaysia was one country that was able to reduce the degree of short-term speculation through a combination of various measure. At one point net inflows of capital actually went into the negative. Thai authorities, on the other hand, were unwilling to intervene to take control of their current accounts deficit. They felt that it was inappropriate for a government to intervene on behalf of a deficit that was caused purely by the private sector. Similarly, in Indonesia also the current account deficit started becoming a representation of private investments. Theories, like the one expressed by Cordon, imply that market forces will take care of any current account deficit. However, in an unusual situation like this, where enormous amounts of capital is available for short-term profit, private agents do not always behave rationally. These countries themselves provided investors with conditions that led to irrational behaviour. The adoption of a fixed exchange rate and an absolute commitment to an unregulated capital account made for good hunting. In these instances measures to keep the current account under control are essential. Through this entire process, Thai governments were playing a delicate game trying to balance the exchange rate and the interest rate. It was imperative for these economies that the exchange rate should not appreciate. They engaged in sterilisation operations in order to keep the exchange rate at certain level. However these activities caused interest rates to increase, which again caused more foreign capital to come into the countries. The East Asian economies, by the mid 90?s were like a card house. Their foundation cards were foreign investment and a fixed exchange rate. Foreign investment had provided all the funding for banks in their ill-conceived ventures. It was this money that allowed economies with very basic discrepancies to achieve such high growth rates. 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 that were pegged to the dollar, increased in response to a corresponding increase in the dollar, it set off a chain of events that ended with the destruction of the East Asian economies. The inflation of the baht led to an increase in the current account deficit. Foreign currency reserves were exhausted in an attempt to pay for the deficit. This economic instability caused panic selling by investors. Thailand refused to devalue its currency, and in response interest rates went up in Thailand and in the Philippians. Under increasing pressure that the flight of capital created, the Thai government eventually let the baht float freely. 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 the result that it also ended at a record low of 32.38 against the dollar. As the effects of this currency devaluation swept throughout Southeast Asia, there was a multilateral currency meltdown. Dozens of financial firms in the region were closed and their operations came under scrutiny. Banks stopped extending short-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 of economic instability in the region investors started selling their stakes in these economies. As the money dried up, the entire system that had developed around this money also crumbled. When an economy is built on such delicate cards, 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 of Asia (in fact the entire world) were hit by the crisis, certain countries weathered the crisis better. Singapore and the Philippines, who had exercised come capital control and had placed prudential regulations on their banks, were able to recover from the crisis much faster. In fact, that they were even hit by the crisis is due more to the non-availability of financial information in the region than anything else. The crisis caused general selling by investors in the entire region who did not have time to differentiate between the various amount of economic distress in the region. Essentially, it was due to some level of Contagion. As you can see, a variety of factors went into the destruction of the Southeast Asian economies. The Americans failed to realise that under the conditions that existed in the region, uncontrolled capital liberalisation would not work. The influx of capital overwhelmed societies, which were not equipped with the knowledge to deal with it. The entire system was dependent on a delicate balance between exchange rates and other monetary factors. In the end the over liberalisation of these economies, without sufficient controls led to one of the most dramatic crisis of all time. In response one can not help but wonder if capital mobility is more a need of the west than of the east. Underdeveloped countries need time to develop the institutional framework to handle this new form of Globalisation. Until then, they can not be fully integrated into the world capital market. 335